Accounting and Finance 47 (2007) 599622

M. Accounting Brimble, and A. Hodgson Finance 47 (2007) 0000 Blackwell Oxford, Accounting ACFI 0810-5391 Journal ORIGINAL XXX The Authors compilation UK Publishing and ARTICLES Ltd 2007 AFAANZ

On the intertemporal value relevance of conventional nancial accounting in Australia

Mark Brimblea, Allan Hodgsonb

a Grifth Business School, Grifth University, Brisbane, 4111, Australia Amsterdam Business School, The University of Amsterdam, 1018 WB, the Netherlands

Abstract This paper examines whether the relevance of conventional (earnings focused) accounting information for valuation has declined in Australia over a recent period of 28 years. Motivation is provided by the anecdotal concerns of nancial analysts, accounting regulators, and a cluster of US centric academic research papers that conclude that the relevance of nancial accounting (and earnings in particular) has declined over time. After controlling for nonlinearities and stock price inefciencies, we nd that the value relevance of core accounting earnings has not declined. A possible exception is found for small stocks. We also observe that net book values are relatively less important in Australia when compared to the USA. Our results are informative for investors who require feedback on valuation issues and the International Accounting Standards Board regulators in any further moves towards a balance sheet focus. Key words: Declining value relevance; Core accounting earnings; Nonlinear earnings JEL classication: G10 G14 M41 doi: 10.1111/j.1467-629x.2007.00241.x

1. Introduction This paper examines whether the value relevance of conventional nancial accounting has declined in Australia over a recent 28 year period. By conventional accounting we mean pre-International Financial Reporting Standards (IFRS) that have an income focus based upon conservatism and realisation principles. Motivation is provided by valuation and standard setting issues induced by the declining value relevance literature in the USA and the change to a balance sheet (commercial) focus under IFRS.
Received 30 August 2005; accepted 28 June 2007 by Robert Faff (Editor)

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Many nancial analysts, accounting practitioners, regulators, and the declining value relevance research in the USA contend that conventional nancial accounting has become less relevant for modern corporations and inadequate for decision-making. Specically they cite: (i) a more volatile and service oriented business environment radically different from the one that existed when generally accepted accounting principles (national GAAP) were rst developed; (ii) changes in the sources and levels of risk and a general increase in the volatility of security returns; (iii) historic cost accounting practices that do not account for the signicant increase in the potential sources of future economic benets for rms, especially intangible assets; (iv) the proliferation of technological development; and (v) the increased sophistication and information requirements of investors (see Rimmerman, 1990; Sever and Boisclair, 1990; Elliott and Jacobson, 1991; Jenkins, 1994). Hence, if investors increasingly seek alternative sources of nancial information, this undermines the relative importance of conventional nancial accounting and strengthens a move towards more commercially oriented accounting standards.1 The US literature has a reasonably long history of evidence of a low value relevance of nancial accounting information. The review article by Lev (1989) rst pointed out that accounting earnings explain only approximately 510 per cent of stock returns in the cross-section. Lev argues this is because of the low quality of accounting earnings garbled by noise from accounting manipulations, the higher incidence of temporary items, and the lack of accounting for intangible assets. Other studies conclude that an increasing incidence of negative earnings and non-recurring items has also reduced the value relevance of earnings over time (Hayn, 1995; Basu, 1997). Taken together, the general consensus is that the intertemporal loss in value relevance is concentrated in the earnings component (Collins et al., 1997; Francis and Schipper, 1999; Lev and Zarowin, 1999; Brown et al., 1999).2,3 Whether there has been a loss in value relevance for balance sheet information is more contentious. For example, Collins et al. (1997) and Francis and Schipper (1999) determine empirically that the value relevance of balance sheet items has

Shina and Watts (2001) predict that an overall decline through increased information asymmetry in nancial information and higher search costs leads to a loss in overall economic efciency.

The exception is Landsman and Maydew (2002) who, using event methodology, found no evidence of a decline in the value relevance of earnings announcements around announcement date.
3

Other studies test the impact of other information on value relevance. For example, whether analysts reports are gaining relevance at the expense of earnings (Francis et al., 2002), or whether alternative accounting-based nancial and non-nancial performance metrics are increasing in value relevance; such as EBITDA or industry specic performance measures (Francis et al., 2003).

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increased over time. Whereas Brown et al. (1999) found the opposite, Lev and Sougiannis (1996) and Lev and Zarowin (1999) argue that the balance sheet value relevance decline is driven by the fact that intangibles are generally not capitalised or valued. Dontoh et al. (2007), however, argue that the decline is caused by non-information based (noise) trading on stock markets rather than a decline in the value relevance of accounting. That is, stock markets are becoming less efcient. Nonetheless, this empirical research, in combination with the move towards theoretical models that emphasise the importance of book values (see Ohlson, 1995), supports a move away from an income focus towards a balance sheet focus and a search for non-accounting value relevant information. As a consequence, Rimmerman (1990), Elliott and Jacobson (1991) and Jenkins (1994) outline several policy suggestions: (i) modifying the accounting reporting process so it better falls in line with the needs of a changing business climate; (ii) identifying other forms of competing information so that nancial statements can be expanded; (iii) developing a standard setting policy that requires the aggressive maintenance of value relevance; (iv) setting up review committees to continually investigate the relevance of nancial reporting; and (v) promoting research into value relevance standard setting issues. The rst three suggestions appear to have been inuential on the International Accounting Standards Board (IASB). Through such accounting standards as, IAS 39/AASB 139 and the IASB Agenda Project: Reporting Comprehensive Income, the following changes have been implemented: (i) prot measurement and revenue recognition is now linked to timely recognition; and (ii) the fair value approach has been adopted as a working principle. That is, because the introduction of IFRS in Australia in 2005, the nancial reporting system now targets the change in the value of assets and liabilities, rather than realisation through the earnings process. Effectively, the focus has shifted towards a valuation concept based on the balance sheet with the main users stated to be shareholders and investors.4 The adaption of IFRS accounting principles has not been without controversy with regard to implementation cost, conceptual framework, pragmatic merit, vague and subjective measurements and inconsistent application (see Matolcsy and Wyatt, 2006). What is interesting is that although the declining value relevance research is US centric, the IFRS standards (inuenced by the US research) have been adopted in over 70 countries, but not in the USA.5 To our knowledge there is no published research outside the USA that shows any decline in value relevance of pre-IFRS nancial accounting, and working papers by Canibano et al. (1999) using Spanish data and Wu et al. (2005) using Chinese data, support the opposite conclusion.

4 5

In contrast to a stewardship or agency approach. At last count (December 2006) IFRS is applied in some form by 73 countries.

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The present paper contributes in several other ways by extending the research internationally to Australia and by undertaking a number of methodological renements. We hypothesise that rm conditions, competitive and economic structures, and business culture vary signicantly in a global sense. Hence, there is no compelling reason to assume the US results will also hold in Australia. The methodological renements involve adjusting for transitory items using nonlinear regressions (Freeman and Tse, 1992), possible stock market inefciencies (Aboody et al. 2002), rm size and leverage effects (Atiase, 1995), and for the impact of new economy rms (Core et al., 2003). We nd that: (i) the core value relevance of conventional accounting earnings have not declined over time; (ii) book values do not have as high a predictive power as earnings; (iii) the nature of the relationship with stock prices has changed such that a linear model does not fully abstract the association; and (iv) researchers need to utilize nonlinear models and adjust for potential market inefciencies in their research design. The remainder of the paper proceeds as follows. Section 2 outlines the data and research design, section 3 reports the results, and the conclusions and comments are contained in section 4. 2. Data and Method 2.1. Data A combination of Datastream, Connect 4, and AGSM microche was used to gather all available nancial data over the period 1973 to 2001 for Australian listed rms, excluding nancial rms. Market and accounting variables for the period 19832001 were collected from Datastream and checked against Connect 4, with the remaining (19731982) hand collected from the AGSM microche. The dataset was compiled by starting with the 42 rms listed in 1974 that survived until 2001, and each year adding rms as they became available and survived. Therefore, the yearly rm samples range from a low of 42 rms in 1973 to 255 rms in 2001, after peaking at 270 in 1999. This provided us with an initial sample of 3563 rm year observations, with the yearly breakdowns reported in Panel A of Table 1. This data construction method, however, raises questions about sample bias and changing industry composition over the collection period. We therefore check for industry composition bias by reporting the annual percentage of the rms by their industry groups, as described in Panel B in Table 1. For most industry groups the percentage composition is relatively stable. The exceptions are the leisure and media industries, which have grown from 0 percent to 4 and 8 per cent, and the oil/gas industry, which has fallen from 21.4 to 6.7 per cent. Hence, the dataset might have a bias towards rms more likely to have volatile and temporary earnings, similar to datasets in the USA. Another issue is that we are adding each year to a long-term dataset of rms that might or might not be long term survivors. We take account of this bias in subsequent tests by separately The Authors

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M. Brimble, A. Hodgson/Accounting and Finance 47 (2007) 599622

Table 1 Descriptive statistics Panel A: Sample distribution per year Number of rms 42 42 45 47 49 50 51 51 Number of rms 52 55 57 60 74 76 82 95 Number of rms 142 153 159 163 165 165 186 211

603

Year 1973 1974 1975 1976 1977 1978 1979 1980

Year 1981 1982 1983 1984 1985 1986 1987 1988

Year 1989 1990 1991 1992 1993 1994 1995 1996

Year 1997 1998 1999 2000 2001

Number of rms 244 260 270 265 252

Panel B: Industry membership of sample rms per year Medical and Manufacturing Leisur Media Pharmaceuticals Mining Oil/gas Building Retail Services Other Year (%) (%) (%) (%) (%) (%) (%) (%) (%) (%) 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 21.4 21.4 22.2 25.5 26.5 26.0 25.5 25.5 25.0 27.3 26.3 25.0 27.0 27.6 28.0 25.3 26.1 25.5 24.7 24.5 25.5 25.9 23.7 21.3 23.4 21.9 21.9 22.3 21.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.7 1.4 1.3 1.2 3.2 2.8 3.3 3.8 3.7 3.6 3.1 3.2 3.8 3.7 3.8 3.7 3.8 4.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.8 1.8 1.7 1.4 1.3 1.2 1.1 2.8 3.3 3.8 4.9 4.8 5.6 5.9 7.1 7.0 7.3 7.4 7.5 7.5 7.1 7.1 6.7 6.4 6.1 6.0 5.9 5.9 5.8 5.5 7.0 5.0 5.4 5.3 4.9 5.3 6.3 7.2 7.6 7.4 7.3 7.4 7.0 7.6 7.8 7.7 7.8 7.9 7.9 16.7 16.7 15.6 14.9 14.3 14.0 15.7 15.7 17.3 14.5 14.0 15.0 21.6 23.7 26.8 28.4 28.9 28.1 27.2 26.4 26.1 25.9 23.1 21.3 19.3 18.1 17.4 16.6 17.1 21.4 21.4 22.2 21.3 20.4 20.0 19.6 19.6 19.2 18.2 17.5 16.7 14.9 14.5 13.4 11.6 10.6 9.8 9.5 9.2 9.1 9.3 8.1 7.6 7.0 6.9 6.7 6.8 6.7 14.3 14.3 13.3 14.9 16.3 16.0 15.7 15.7 15.4 16.4 17.5 16.7 13.5 11.8 11.0 11.6 8.5 7.8 8.9 8.6 8.5 8.6 11.8 11.8 12.3 12.7 13.0 12.8 12.7 4.8 4.8 4.4 4.3 4.1 4.0 3.9 3.9 3.8 3.6 3.5 3.3 2.7 2.6 2.4 3.2 4.9 5.2 5.1 5.5 5.5 5.6 5.4 5.7 5.3 5.8 5.9 6.0 6.3 11.9 11.9 13.3 10.6 10.2 12.0 11.8 11.8 11.5 10.9 10.5 10.0 8.1 7.9 7.3 7.4 6.3 6.5 6.3 6.7 6.7 6.2 9.7 10.0 11.1 11.9 12.2 12.5 13.1 2.4 2.4 2.2 2.1 2.0 2.0 2.0 2.0 1.9 1.8 1.8 5.0 4.1 3.9 3.7 3.2 2.8 3.3 3.2 3.1 3.0 2.5 2.2 3.8 3.3 3.8 4.1 3.8 3.6

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Table 1 (continued) Panel C: Descriptive statistics Percentiles Variable Return (Rit) Price (Pit) Earnings (Earnit) Change in earnings (Earnit) Book value (BVit) Size (Sizeit) Financial leverage (FLevit) N 3563 3563 3563 3289 3563 3563 3563 Mean 0.168 1.197 0.081 0.009 0.956 0.523 0.329 25 0.100 0.850 0.017 0.031 0.444 0.377 0.021 50 0.120 1.070 0.059 0.001 0.719 0.526 0.143 75 0.450 1.410 0.093 0.025 1.113 0.680 0.383

This table presents descriptive statistics for the pooled sample for the period 19732001 inclusive. All market variables are obtained from Datastream. Accounting variables for the period 19832001 are also collected from Datastream and Connect 4 with the remaining (19731982) collected from AGSM microche. Panel A presents the number of rms sampled in each yearly interval and panel B reports the percentage industry membership of sample rms based on Datastream industry codes. Panel C presents standard descriptive statistics for all accounting variables included in the study where Rit is the t-period simple return, Pit is opening stock price, Earnit is accounting earnings to ordinary shareholders, Earnit is the yearly change in Earnit, BVit is opening accounting book value, Sizeit is the log of opening market capitalisation, and Flevit is the ratio of total assets to total liabilities.

analysing young rms less than 3 years old and by rerunning the regressions on rms that had survived at least 15 years and comparing results to our full sample.6 Panel C reports descriptive statistics for the full dataset. The descriptive statistics indicate a relative normal distribution with the means approximating the 50 percentile range and spread evenly across the percentiles. The exception is the nancial leverage variable, which is skewed towards the high end. As a robustness check we re-ran these statistics separately for individual years.7 For the most part, median and mean values were approximately equal with some exceptions around the later years of the 1990s during the period of the stock market bubble. Furthermore, median size increased in relatively the same fashion, with small rms increasing from $6.5m to $65m and large rms from $76.2m to $1086.8m. A feature of the data was the reduction in median book value/market value from 1.10 to 0.75 and an increase in nancial leverage from 2.64 to 32.75 per cent, thus indicating changing business conditions and possibly more volatile earnings outcomes.

There were only minor differences in R2, with the survivor rms for M2 M5 described in S2.2, at 1 per cent higher for the earnings models, and insignicant differences for the book and combined models. We thank the reviewer for pointing out this potential sampling bias. Not reported but available on request.

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Three models are used to examine: (i) earnings relevance; (ii) balance sheet relevance; and (iii) combined earnings and balance sheet relevance; all derived from a modied Ohlson model. For each basic model a series of linear, nonlinear and price adjusted regressions are estimated. The functional form of each is presented below. 2.2. Modelling and econometric methods 2.2.1. Value relevance of accounting information The value of a rms equity can be expressed as a combined function of earnings and book value via Ohlson (1995): Pit = 0 + 1Earnit + 2 BVit + it , (1)

where Pit is the price per share of rm i at scal year end t 3 months after scal year-end, Earnit is earnings per share of rm i at the end of year t, BVit is the book value per share of rm i at the end of year t, and it is other value relevant information of rm i in year t orthogonal to earnings and book value. We then apply a series of linear and nonlinear regression models, as well as additional control variables, to assess the intertemporal long-term value relevance of the accounting components. 2.2.2. Linear models There are fundamentally two ways the above relationship can be tested. Use model (1) as it stands and test for the impact on price levels and/or analyse the impact on changes in prices (returns). We test for both effects. For the returns model we take the rst difference of equation (1) and divide through by the number of shares and scale by Pit1 (see Francis and Schipper, 1999).8 By taking rst differences the test is conned to the impact of earnings, but we are able to analyse the joint impact of the earnings level and the permanent impact of earnings changes as suggested by Easton and Harris (1991). The regression is as follows: M1 Rit = 0 + 1Earnit + 2 Earnit + it . (2)

Pit Pit1 + Dit , where Pit is stock price of rm i at the end Pit1 of period t, lagged 3 months, Pit1 is stock price of rm i at the beginning of period t and Dit is dividends of rm i for period t, with all earnings components also scaled by lagged price to control for any positive correlation with the coefcient of variation of the scale factor (see Brown et al., 1999). As a robustness check suggested by the referee we reran all earnings regressions by scaling by the net book value of assets. There were no signicant differences.
8

Return (Rit) is dened as Rit =

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We then apply three price level tests previously used by Collins et al. (1997) that allow us to directly compare the incremental explanatory power that earnings per share and book value per share have for prices. The rst price level model uses the earnings relation in equation (1) and adds the change in earnings suggested by the work of Foster (1977) and Easton and Harris (1991) as follows: M2 Pit = 0 + 1Earnit + 2 Earnit + it . (3)

The earnings response coefcient (ERC) is then represented by the sum of 1 and 2 from both (M1) and (M2). The book value relevance is then dened as: M3 Pit = 0 + 1BVit + it , (4)

and the combined earnings and book model is the same as equation (1). M4 Pit = 0 + 1Earnit + 2 BVit + it . (5)

The combined model estimates the dual impact of earnings and book value in a modied Ohlson (1995)9 model and has previously been applied by Lev and Zarowin (1999), Collins et al. (1997) and Francis and Schipper (1999). When running our models we apply the Whites (1980) consistent covariance matrix to adjust for heteroskedasticity and Cooks distance statistics to ensure that no individual observation is signicantly inuencing the regression results. The 2 , coefcients of determination from the models (M2)(M5) are denoted REM1 2 2 2 REM 2 , RBM1 and RCM1. To determine if there is a statistically signicant increase or decrease in the value relevance of the accounting information of the sample period a time trend regression is run on the series of R2 and ERC (for the earnings models) statistics for each model: Rt2 = 0 + 1TIME + it and ERCt = 0 + 1TIME + it . (6a) (6)

We then re-estimate the above linear and time trend regressions using nonlinear techniques and make adjustments to control for a number of factors including size, leverage, age, industry and negative earnings.

This terminology is used in accordance with the prior literature in this area of research. However, the strict version of the Ohlson model regresses prices on book values and future excess earnings.

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2.3. Extensions 2.3.1. Nonlinear modelling Our rst extension controls for transitory factors in the accounting information using a nonlinear (inverse) arctan model specication (see Freeman and Tse, 1992). Freeman and Tse, for example, argue that a linear regression based on a constant marginal response of the dependant variables to the independent variable, does not capture the economic relationship. This will occur if transitory items, such as nonpersistence in positive and negative accruals, rm size, and systematic risk are correlated with the magnitude of the unexpected components in the independent variables. If this is the case then a nonlinear s-shaped mathematical function will more accurately reect economic reality, with the abscises capturing the core marginal responsiveness of earnings to price. All the previously stated models (M1M4) are then re-estimated using the inverse tangent nonlinear model as follows: Rit = 0 + 1 arctan( 2 Earnit + 3 Earnit ) + it , Pit = 0 + 1 arctan( 2 Earnit + 3 Earnit ) + it , Pit = 0 + 1 arctan( 2 BVit ) + it , Pit = 0 + 1 arctan( 2 Earnit ) + 3 arctan( 4 BVit ) + it . 2.3.2. Market inefciencies A basic premise in the value relevance literature is that stock market prices are semi-strong efcient in that they reect fundamental value by incorporating publicly available (nancial accounting) data in an unbiased manner. Therefore, if there is no contemporaneous relation, or the relation is low, then it is routinely assumed that accounting data has no or little price relevant information. However, what if stock prices are derived from an irrational bubble, or price momentum, or investor overreaction? Aboody et al. (2002) develop a procedure to adjust contemporaneous stock prices for future risk adjusted price changes to capture delayed market reactions. Therefore, allowing for the impact from price mean reversion and controlling for price bubbles. We term this model the market efciency model and incorporate these innovations into our earnings, book, and combined models to control for future information in the stock price time series. The empirical model is: it = Bit Xit + it , P (9) (7) (8) (9) (10)

1 + Rit +1 it = P , Xit is the independent variable (earnings, book value, where P v it 1 + Rit +1 v or both), Rit+1 is next period cum-div stock return, Rit +1 is next period intrinsic return proxied for by next period size decile returns, and Pit is t period ending price. The Authors
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3. Results 3.1. Earnings relationships Panel A of Tables 2 and 3 report the R2 and ERCs for each yearly regression in the sample (19742001) for the price return model (M1) and the price level model (M2). The associated time trend regression results are reported in panel B (the predictive (R2) and explanatory power (ERC)). There are several consistent

Table 2 The long-term association between price returns and earnings levels and earnings changes M1: Rit = 0 + 1Earnit + 2 Earnit + it ; Rit = 0 + 1 arctan( 2 Earnit + 3 Earnit ) + it Panel A: Yearly regression results Linear market efciency model R2 0.02 0.00 0.02 0.15 0.11 0.06 0.04 0.18 0.06 0.02 0.17 0.05 0.02 0.01 0.08 0.09 0.19 0.05 0.03 0.01 0.02 0.07 0.05 0.16 0.10 0.03 0.02 0.27 0.07 ERC 0.800 0.504 1.225 3.577 2.148 2.544 5.993 4.062 1.555 0.708 3.765 2.584 3.178 6.178 1.835 2.965 0.483 0.246 0.255 0.763 2.896 0.835 14.414 1.418 0.531 0.376 0.903 6.470 2.109 Nonlinear market efciency model R2 0.04 0.01 0.04 0.20* 0.13 0.08 0.11* 0.29** 0.09* 0.05 0.19 0.13** 0.04 0.06 0.10 0.16* 0.22** 0.16*** 0.06* 0.01 0.07 0.11 0.08** 0.19*** 0.11** 0.08* 0.03 0.27 0.11 ERC 0.945 0.295 3.061 6.563 2.136 2.886 8.906 32.106 1.583 5.252 3.669 7.200 4.912 11.066 2.934 3.281 1.276 7.361 1.188 0.760 4.230 2.041 45.291 12.491 0.732 10.962 1.382 6.292 6.716

Linear model Year 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Mean R2 0.18 0.02 0.08 0.27 0.18 0.14 0.05 0.29 0.08 0.14 0.08 0.13 0.09 0.05 0.05 0.10 0.14 0.04 0.05 0.03 0.04 0.09 0.01 0.13 0.11 0.06 0.02 0.17 0.10 ERC 1.388 0.274 0.455 1.366 1.649 2.241 1.839 4.262 1.259 0.973 1.621 2.319 2.963 7.643 0.653 0.902 0.138 0.111 0.137 0.350 0.647 0.538 0.197 1.098 0.288 0.502 0.124 0.512 0.716

Nonlinear model R2 0.21 0.07 0.08 0.27** 0.20 0.16** 0.08 0.39** 0.12* 0.16 0.09 0.15 0.16* 0.06 0.09* 0.22*** 0.14 0.13*** 0.14** 0.11** 0.06* 0.12* 0.01 0.18*** 0.13** 0.07* 0.07** 0.19** 0.14 ERC 1.427 0.693 0.469 1.350 1.735 2.239 4.339 22.719 5.132 0.971 1.596 2.934 4.586 7.905 3.026 6.446 0.182 0.481 0.373 0.933 0.928 0.539 0.307 7.392 0.425 0.532 0.147 1.156 2.017

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Table 2 (continued) Panel B: Time trend regression results Model Linear earnings: R2 Linear earnings: ERC Nonlinear earnings: R2 Nonlinear earnings: ERC Linear market efciency: R2 Linear market efciency: ERC Nonlinear market efciency: R2 Nonlinear market efciency: ERC Alpha 19.901*** 14.924*** 17.560*** 14.897*** 12.950*** 14.188*** 13.079*** 13.794 Time 42.341** 42.324* 32.578 0.194 20.859 0.148 12.792 0.105

609

R2 0.10 0.09 0.05 0.03 0.01 0.04 0.03 0.02

Adjusted R2 and ERC statistics are reported for regression models over the period 1974 2001: P it P it 1 + Dit , where Pit is stock price of rm i at the end of period t, P it 1 lagged 3 months, Pit1 is stock price of rm i at the beginning of period t and Dit is dividends of rm i for period t. Earnit is the earnings per share orthogonal to Earnit change in earnings per share both 1 + Rit +1 scaled by opening market price. Pit is adjusted in the market efciency, where Pit equals P, v it 1 + Rit +1 v Rit+1 is the next period cum-div stock return and Rit +1 is next periods intrinsic return proxied for by next periods size decile returns. The ERC is calculated as 1 + 2 in the linear model and 1 (2 + 3) in the nonlinear model. J-tests are conducted to determine whether the nonlinear models are superior to their linear equivalents on the R2. Panel B presents results of time trend regressions on the R2 and ERC series in the form of R2 t = 0 + 1TIME + it and ERCt = 0 + 1TIME + it and *, **, *** represent statistical signicance at the 10, 5 and 1% levels, respectively. Return (Rtit) is dened as Rit = Table 3 The long-term association between stock prices and earnings levels and earnings changes M2: P it = 0 + 1Earnit + 2 Earnit + it ; P it = 0 + 1 arctan( 2 Earnit + 3 Earnit ) + it Panel A: Yearly regression results Market efciency model R2 0.19 0.09 0.17 0.22 0.14 0.12 0.12 0.34 0.06 0.26 0.17 ERC 2.945 1.719 1.483 2.191 2.468 2.331 3.685 3.945 1.963 2.439 3.925 Nonlinear market efciency model R2 0.24 0.18 0.25* 0.26 0.19 0.17 0.16 0.37 0.15* 0.29** 0.24* ERC 2.993 9.008 3.836 2.613 2.485 2.696 3.862 4.169 1.659 2.444 7.122

Linear model Year 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 R2 0.31 0.06 0.20 0.24 0.19 0.15 0.08 0.29 0.18 0.16 0.17 ERC 4.173 4.714 1.589 0.736 2.379 0.021 0.493 4.745 0.300 1.970 1.728

Nonlinear model R2 0.35 0.15** 0.24*** 0.28*** 0.23 0.19*** 0.15 0.32*** 0.21*** 0.22*** 0.22* ERC 4.472 6.455 1.993 0.889 2.899 0.141 0.461 4.764 0.346 2.053 2.010

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Panel A:(continued) Yearly regression results Table 3 Market efciency model R2 0.09 0.12 0.31 0.51 0.61 0.15 0.15 0.02 0.18 0.17 0.08 0.07 0.16 0.08 0.02 0.06 NA 0.17 ERC 10.081 7.821 2.471 3.581 2.742 2.371 0.363 0.234 3.556 1.102 1.486 1.370 2.189 0.942 0.674 3.424 NA 2.722 Nonlinear market efciency model R2 0.13 0.05 0.35** 0.58*** 0.68*** 0.28*** 0.18*** 0.10** 0.19* 0.19** 0.18*** 0.11** 0.22*** 0.11** 0.10*** 0.21*** NA 0.23 ERC 10.261 2.174 2.345 7.207 2.637 2.127 2.852 0.986 3.368 3.738 4.281 3.943 6.048 1.882 3.830 2.712 NA 3.825

Linear model Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Mean R2 0.12 0.20 0.06 0.17 0.10 0.14 0.06 0.16 0.17 0.04 0.12 0.07 0.13 0.13 0.05 0.06 0.18 0.14 ERC 2.782 7.104 2.762 4.875 1.581 0.287 0.225 0.190 0.829 1.077 1.438 0.680 1.652 0.615 0.750 0.146 0.855 1.809

Nonlinear model R2 0.18 0.25*** 0.13*** 0.28*** 0.20*** 0.18** 0.16*** 0.22** 0.31** 0.10*** 0.22*** 0.12* 0.23*** 0.26*** 0.14* 0.18** 0.27*** 0.23 ERC 3.447 8.290 2.588 7.193 6.943 0.461 1.885 0.251 1.213 1.371 2.827 3.195 6.682 1.427 0.989 0.969 3.012 2.830

Panel B: Time trend regression results Model Linear earnings: R2 Linear earnings: ERC Nonlinear earnings: R2 Nonlinear earnings: ERC Linear market efciency: R2 Linear market efciency: ERC Nonlinear market efciency: R2 Nonlinear market efciency: ERC Alpha 8.135** 16.806** 3.722 5.459 6.177 11.740 7.462 10.980 Time 0.004** 0.084** 0.002 0.026 0.003 0.055 0.004 0.054 R2 0.22 0.11 0.02 0.03 0.00 0.00 0.02 0.02

Adjusted R2 and ERC statistics are reported for regression models over the period 19742001: P it P it 1 + Dit , where Pit is stock price of rm i at the end of period t, P it 1 lagged 3 months, Pit1 is stock price of rm i at the beginning of period t and Dit is dividends of rm i for period t. Earnit is the earnings per share orthogonal to Earnit change in earnings per share both Return (Rtit) is dened as Rit = 1 + Rit +1 scaled by opening market price. Pit is adjusted in the market efciency, where Pit equals P, v it 1 + Rit +1 v Rit+1 is the next period cum-div stock return and Rit +1 is next periods intrinsic return proxied for by next periods size decile returns. The ERC is calculated as 1 + 2 in the linear model and 1 (2 + 3) in the nonlinear model. J-tests are conducted to determine whether the nonlinear models are superior to their linear equivalents on the R2. Panel B presents results of time trend regressions on the R2 and ERC series in the form of R2 t = 0 + 1TIME + it and ERCt = 0 + 1TIME + it and *, **, *** represent statistical signicance at the 10, 5 and 1% levels, respectively.

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results that can be observed from both tables. Using a nonlinear model improves both explanatory and predictive power, adjusting for market inefciency improves explanatory power but not always predictive power, and the best explanatory power model is derived from using nonlinear and market efciency adjustments. The linear results for the return model document a decline in the value relevance of Australian company accounting earnings over this period with the two time trend regressions negative and statistically signicant. The results for the price level model in Table 3 are similar. The mean R2 for price returns (price levels) over the period is 10 per cent (14 per cent) with an average ERC of 0.716 (1.809). These results provide support for the US studies and the conclusion that investors would probably increasingly rely upon alternative information sources over time (Collins et al., 1997; Francis and Schipper, 1999; Lev and Zarowin, 1999; Brown et al., 1999). However, when the temporary components of earnings are further controlled by applying a nonlinear regression, the negative value relevance decline in earnings dissipates. Furthermore, the nonlinear price return (price level) model outperforms the linear model in 17 (24) of the 28 yearly regressions (as measured by a J-test), with a mean R2 for the period of 14 per cent (23 per cent) and mean ERC of 2.017 (2.830).10 Because the nonlinear model more aptly captures the relationship between accounting earnings and prices, results suggest that the core relationship has not declined over time: rather it has remained stable. The J-tests also show that the nonlinear models are more appropriate in more recent years. Consequently, users of accounting earnings information need to be aware of the impact of transitory items (and their increased impact over time) and take them into account in their decision-making. The second issue is the impact of market inefciency on the relationship. The last four columns of Tables 2 and 3 present summary results of market efciency adjusted linear and nonlinear regressions. Both tables show that controlling for market inefciency results in increased explanatory power, with average ERCs of 2.109 and 6.716 for the price returns model (Table 2) and 2.722 and 3.825 for the levels model (Table 3), all higher than their unadjusted counterparts. R2 are generally lower than their unadjusted counterparts, but the J-tests indicate that the nonlinearity is also increasing over time. Once again, there is no evidence of a signicant decline in the value relevance of earnings, as reported in Panel B of Tables 2 and 3.

We also ran pooled regressions for the rst half of the sample period (1974 1987) compared to the second half (1988 2001) for the levels model. The nonlinear models outperformed the linear to a greater extent in more recent times: the nonlinear R 2 (ERC) was 23 per cent (13 per cent) higher than the linear in the rst period, but a much greater 45 per cent (60 per cent) higher in the second period.

10

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What do these results tell us about the intertemporal relationship between earnings and stock price changes and price levels in Australia? First, adjustments are required for the increased temporary components of earnings to uncover core earnings and for increased inefciencies in stock markets. Once these adjustments are undertaken there is no evidence of any decline in the value relevance of earnings. Therefore, we conclude that increasing market inefciency over time is partially responsible for the decline in the value relevance of accounting earnings (ERC) in Australia. Furthermore, the nonlinear model adjusted for market inefciency is generally the superior explanatory model for prices (ERC) and the simpler nonlinear model is the superior predictive model ( R 2). What is obvious from our tests is that linear association models are inadequate to capture the dynamic nature of stock markets and commerce in general; namely: (i) the changing functional relationship with prices; (ii) markets that are more volatile and possibly less efcient; and (iii) the increasing nonlinearities over time. Finally, we suggest any conclusion that conventional accounting earnings have lost their relevance in Australia is premature: the nancial world is simply more complex. 3.2. The balance sheet relation Summary regression results from the examination of the long-term association between stock prices and book values are presented in Table 4. These indicate that the value relevance of book values for prices has remained stable over the period 19742001 in Australia. Also of note is the strength of the association, as measured by R2, is lower than that of earnings (9 per cent cf 14 per cent) and that reported for the balance sheet in the USA (2545 per cent in Francis and Schipper, 1999). This is slightly improved when both nonlinearities (R2 of 12 per cent) and market efciency (R2 of 11 per cent) are controlled, with the J-tests indicating that the nonlinear models outperform their linear counter parts in 14 of the 28 models each, but most of these come in the later years. Once again, as with the earnings models, the importance of the nonlinearities and market inefciency adjustments increase over time. Of note, is that the linear market efciency adjusted model provides the lowest average R2 of the four models used at 6 per cent and also illustrates a statistically signicant decline in the value relevance of book values (see Panel B of Table 4). In terms of prior US evidence, previous linear results suggested an increase in the value relevance of book value over time (Collins et al., 1997; Francis and Schipper, 1999).11 In a dissenting paper Brown et al. (1999), who

11 This study uses total assets and total liabilities as separate regression variables rather than a net book value variable.

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Table 4 The long-term association between stock prices and net book values M3: P it = 0 + 1 BV it + it ; P it = 0 + 1 arctan( 2 BV it ) + it Panel A: Yearly regression results Market efciency model R2 0.05 0.02 0.05 0.10 0.19 0.15 0.05 0.31 0.06 0.02 0.13 0.02 0.02 0.10 0.08 0.05 0.04 0.02 0.01 0.03 0.02 0.02 0.02 0.04 0.05 0.05 0.02 NA 0.06

613

Year 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Mean

Linear model R2 0.11 0.07 0.16 0.18 0.14 0.06 0.06 0.26 0.13 0.08 0.03 0.04 0.05 0.06 0.04 0.06 0.13 0.13 0.06 0.06 0.05 0.05 0.07 0.08 0.16 0.07 0.10 0.10 0.09

Nonlinear model R2 0.13 0.08 0.18** 0.20*** 0.17 0.10 0.08* 0.27*** 0.16 0.10 0.05 0.09 0.10 0.08** 0.07 0.07 0.18*** 0.14 0.07 0.12*** 0.08* 0.11*** 0.11** 0.08 0.24*** 0.18*** 0.13*** 0.12** 0.12

Nonlinear market efciency model R2 0.08 0.06 0.08 0.16 0.12 0.19** 0.12* 0.32 0.15** 0.05 0.04 0.05 0.13* 0.04 0.07 0.19*** 0.23*** 0.12*** 0.04*** 0.08*** 0.10*** 0.04 0.06** 0.04 0.18** 0.15** 0.14*** NA 0.11

Panel B: Time trend regression results Model Linear book value: R2 Nonlinear book value: R2 Linear market efciency: R2 Nonlinear market efciency: R2 Alpha 3.166 0.924 6.723** 1.374 Time 0.001 0.000 0.003** 0.001 R2 0.02 0.00 0.12 0.00

This table presents summary yearly regression results over the period 19742001. Where Pit is closing price and BVit is book value per share both of which are scaled by opening market 1 + Rit +1 price. Pit is adjusted in models 1 and 5, where Pit equals P , Xit = the independent variable v it 1 + Rit +1 v (earnings, book value, or both), Rit+1 = next period cum-div simple stock return and Rit +1 = next period intrinsic return proxied for by next period size decile returns. J-tests are conducted to determine whether the nonlinear models are superior to their linear equivalents. Panel B presents results of time trend regressions on the R2 series for each model in Panel A in the form of R2 and t = 0 + 1TIME + it *, **, *** represent statistical signicance at the 10, 5 and 1% levels, respectively.

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correct for the scale effects, report a decline in that relationship.12 Interestingly, our linear results, which also control for scale effects, show a relatively stable, albeit weak, pricebook value relationship in Australia, with results strengthened by controlling for nonlinearities. Therefore, we conclude that net book value of assets have never been a strong indicator of value in Australia and continue to be weakly relevant. 3.3. Combined earnings and book relation The combined linear earningsbook value model provides evidence of a decline in the value relevance of the combined accounting information over time, as indicated by the yearly and time trend regression results presented in Table 5. The time trend results are similar to those of the earnings models, with the addition of net book value as an additional explanatory variable not offsetting the decline in the usefulness of earnings. Once again, nonlinearities and market inefciencies play a signicant role in the association between accounting information and prices, with the statistically signicant decline in the relationship disappearing when they are controlled. Similar to the results in Tables 2, 3 and 4, there are increasing nonlinearities over time. Similarly, we note that the addition of net book values to the equation adds very little predictive power and is less relevant than accounting earnings for rm valuation in Australia. Consequently, another conclusion is that an in-depth understanding of core operating earnings has been the most important valuation element in Australia over the last 30 years or so. 3.4. Further extensions 3.4.1. Firm size Prior research indicates that rm size is a key factor that inuences the earnings returns relationship (Atiase, 1985; Hodgson and Stevenson-Clarke, 2000a). This is related to the relative information environment, such as a lower level of analyst following for small rms compared to large rms, higher levels of information disclosure by large rms, greater numbers of start-up rms in the small rm category, and the greater propensity of small rms to report losses (Hayn, 1995). We operationalise size by splitting the yearly samples into small and large rm subsets determined by the median value of opening market capitalisation. The linear and nonlinear regressions are then re-estimated for each size sub-sample for the price level models (M2M4). This approach is selected (rather than a dummy variables approach) because it provides

12

Lev and Zarowin (1999) do not estimate a balance sheet model.

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Table 5 The long-term association between stock price and combined earnings levels and net book values M4: P it = 0 + 1Earnit + 2 BV it + it ; P it = 0 + 1 arctan( 2 Earnit ) + 3 arctan( 4 BV it ) + it Panel A: Yearly regression results Market efciency model R2 0.06 0.02 0.07 0.19 0.31 0.05 0.19 0.29 0.04 0.06 0.28 0.03 0.12 0.19 0.15 0.05 0.21 0.15 0.04 0.14 0.12 0.05 0.10 0.14 0.10 0.08 0.22 NA 0.13

615

Year 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Mean

Linear model R2 0.25 0.10 0.24 0.28 0.42 0.10 0.10 0.31 0.15 0.21 0.16 0.21 0.11 0.14 0.03 0.14 0.18 0.13 0.11 0.08 0.09 0.10 0.05 0.12 0.18 0.09 0.11 0.19 0.16

Nonlinear model R2 0.29 0.19 0.19 0.20 0.47* 0.10 0.10 0.50*** 0.29*** 0.25 0.29* 0.26 0.18** 0.17 0.11* 0.23*** 0.22*** 0.21*** 0.17** 0.23*** 0.28*** 0.16*** 0.10** 0.25*** 0.36*** 0.21*** 0.19*** 0.26*** 0.23

Nonlinear market efciency model R2 0.05 0.08 0.13 0.27* 0.19 0.21* 0.24** 0.55*** 0.26*** 0.13** 0.29** 0.11* 0.19** 0.20* 0.22* 0.34*** 0.25*** 0.25*** 0.16*** 0.18*** 0.16*** 0.20*** 0.16*** 0.31*** 0.30*** 0.18*** 0.17*** NA 0.22

Panel B: Time trend regression results Model Linear: R2 Nonlinear: R2 Linear market efciency: R2 Nonlinear market efciency: R2 Alpha 10.154*** 3.048 0.649 2.515 Time 0.005*** 0.001 0.001 0.001 R2 0.21 0.00 0.00 0.00

This table presents summary yearly regression results over the period 1974 to 2001 for models: Where Pit is closing price, Earnit is the earnings per share and BVit is book value per share all of which 1 + Rit +1 are scaled by opening market price. Pit equals P , Xit = the independent variable (earnings, v it 1 + Rit +1 v book value, or both), Rit+1 is next period cum-div simple stock return and Rit +1 is next period intrinsic return proxied for by next period size decile returns. J-tests are conducted to determine whether the nonlinear models are superior to their linear equivalents. Panel B presents results of time trend regressions on the R2 series for each model in Panel A in the form of R2 . *, **, *** t = 0 + 1TIME + it represent statistical signicance at the 10, 5 and 1% levels, respectively.

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two independent series of R2 statistics so that a time trend regression can be estimated. The results for small and large rms are presented in Table 6. They provide evidence that any value relevance decline occurs in small rms. In the linear regressions there is a statistically signicant decline in all three models (earnings, book values and the combined model) over the period. Furthermore, this pattern persists for all the nonlinear models showing that core earnings value relevance also declined. Although the nonlinear R2 and ERC do improve, the improvement is insufcient to mitigate the decline in value relevance of accounting information for small rms. However, although large rm earnings also exhibit a statistically signicant decline in linear value relevance over time, after controlling for nonlinearities there is statistically no signicant decline. Hence, whereas nonlinearities appear to be of increasing importance over time, the nonlinear models outperform their linear equivalents to a far greater extent in the later part of our sample (P2) in comparison to the earlier part (P1): these are of greater relevance to large rms. Therefore, rm size is an important factor in the accounting data/market value equation. However, there is also an important caveat. The R2 for small rms in the rst period is much higher when compared to large rms (41 per cent cf 27 per cent), but in the later period of our sample they are about the same (22 per cent cf 24 per cent). Hence, although there has been a decline for small rms, this reduction has only been down to levels that match overall averages, which still signals an important role for nancial accounting in price valuation.

Table 6 The long-term association between accounting information and stock prices: the impact of rm size Panel A: Mean R2 Small rms Linear model Model P1 EARN BV OHLS P2 EARN BV OHLS R2 ERC Nonlinear model R2 ERC J-test Large rms Linear model R2 ERC Nonlinear model R2 ERC J-test

0.32 0.17 0.28 0.11 0.10 0.14

3.13

0.40 0.24 0.41 0.21 0.14 0.22

4.25

5/14 6/14 9/14 8/14 6/14 9/14

0.15 0.13 0.21 0.10 0.09 0.16

3.16

0.23 0.18 0.27 0.20 0.12 0.24

6.71

8/14 4/14 2/14 11/14 6/14 12/14

1.01

2.19

1.97

6.70

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Table 6 (continued) Panel B: Time trend regression results Model Small Firms Linear: R2 EARN BV OHLS Linear: ERC nonlinear: R2 EARN BV OHLS nonlinear: ERC Large Firms Linear: R2 EARN BV OHLS Linear: ERC nonlinear: R2 EARN BV OHLS nonlinear: ERC Alpha Time

617

R2

28.266** 9.378* 21.059** 232.066** 28.550** 11.559* 28.890** 244.365**

0.014** 0.005* 0.010** 0.116** 0.014** 0.006* 0.014** 0.121**

0.45 0.11 0.24 0.26 0.50 0.13 0.38 0.24

7.195*** 4.327 8.797* 150.178 3.733 7.049 7.589* 87.789

0.004** 0.002 0.004* 0.074 0.002 0.003 0.004 0.041

0.13 0.00 0.07 0.03 0.01 0.05 0.08 0.00

This table presents summary yearly regression results over the period 1974 to 2001 for the price models: P it P it P it P it P it P it = 0 + 1Earnit + 2 Earnit + it , = 0 + 1BVit + it , = 0 + 1Earnit + 2 BVit + it , = 0 + 1 arctan( 2 Earnit + 3Earnit ) + it , = 0 + 1 arctan( 2 BVit ) + it , = 0 + 1 arctan( 2 Earnit ) + 3 arctan( 4 BVit ) + it , (EARN) (BV) (OHLS) (EARN) (BV) (OHLS),

where Pit is closing price, Earnit is the earnings per share and is orthogonal to Earnit, Earnit is change in earnings per share and BVit is book value per share all scaled by opening market price. The ERC is calculated as (b1 + b2) and 1(2 + 3) are the linear and nonlinear models, respectively. Panel A presents mean yearly R2 regression results for each model, where P1 is the sub-sample period of 1974 1987 and P2 is the sub-sample period 19882001. The J-test column refers to the number of years in which the nonlinear model outperformed the linear model at the 10% level or better and Panel B presents results of time trend regressions on the R2 and ERC series for each model in Panel A in the form of Rt2 = 0 + 1TIME + it and ERCt = 0 + 1TIME + it . *, **, *** represent statistical signicance at the 10, 5 and 1% levels, respectively.

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3.4.2. Leverage There are several competing theories related to the impact of nancial leverage on rm value.13 Empirical support for leverage having a signicant impact on rm value is provided by Kim et al. (1992) and Hodgson and StevensonClarke (2000b), who show that the level of nancial leverage inuences both actual and expected earnings and the degree to which earnings are permanent or transitory. To examine this aspect, the above size sample is split at the median value of nancial leverage (debt/equity ratio) for each yearly interval and then the linear and nonlinear regressions are re-estimated for each sub-sample. Results show there is no material change to the size and, therefore, we conclude that the small size decline in value relevance was not caused by a leverage factor (results reported in Table 6).14 3.4.3. Age and new economy rms Core et al. (2003) examine the earningsprice return relation after controlling for rm age and industry membership within a long window cross-sectional context. They argue that the new economy period (NEP) (proxied for by industry clusters including computer software and hardware, pharmaceuticals, electronic equipment and telecommunications) exhibits non-traditional relationships between market and nancial variables and that including them in a broad cross-sectional regression skews the results. This is because young rms, within their rst few years of trading, are more likely to report losses and have insufcient trading history to develop a market reputation, thus making price valuation more uncertain. The impact of controlling for NEP and young rms is also examined through the use of dummy variables added to the linear and nonlinear models.15 We provide weak evidence, in the form of statistically signicant dummy coefcients (see Table 7), in linear regression tests of both of these effects in the Australian environment. The negative, statistically signicant coefcients in panel A of Table 6 suggest that accounting information has a stronger association with market value for comparatively young rms. Furthermore, the positive

13

These are known as the default theorem, the maximum debt theorem, the optimal leverage theorem and the irrelevance theorem (see Modigliani and Miller, 1958; Modigliani and Miller, 1963; Ross, 1977; Dhaliwal et al., 1991). Results are available from the authors on request.

14 15

We dene young rms as <3 years trading, but as Core et al. (2003) point out there are likely to be systematic differences across time periods with IPO rms in earlier years having a longer operating history before listing than IPO rms in later years. We acknowledge that such changes in young rm characteristics across time periods might bias the results. We thank the reviewer for pointing this out.

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Table 7 The long-term association between accounting information and stock prices: the impact of age and new economy rms Panel A: Controlling for Firm Age Linear models Year 1995 1996 1997 1998 1999 EARN 0.025 0.013 0.136 0.329*** 0.355** BV 0.054 0.103 0.146 0.319** 0.468* OHLN 0.045 0.029 0.118 0.183** 0.307** Nonlinear models EARN 0.045 0.400 0.164* 0.336 0.184 BV 0.186 0.123 0.162 0.243 0.073 OHLN 0.213 0.113 0.150 0.248** 0.084

Panel B: Controlling for New Economy Firms Linear models Year 1997 1998 1999 2000 2001 EARN 0.096 0.192* 0.334** 0.174** 0.102 BV 0.028 0.138 0.516** 0.175* 0.248*** OHLN 0.034 0.060 0.186* 0.112 0.132 Nonlinear models EARN 0.118 0.332 1.487** 0.392 0.175 BV 0.022 0.135 1.478** 0.151 0.011 OHLN 0.107 0.153* 1.487** 0.085 0.105

This table presents summary regression statistics for the following models: P it P it P it P it P it P it = 0 + 1Earnit + 2 Earnit + Dit + it , = 0 + 1BVit + Dit + it , = 0 + 1Earnit + 2 BVit + Dit + it , = 0 + 1 arctan( 2 Earnit + 3Earnit ) + 4 + it , = 0 + 1 arctan( 2 BVit ) + 3 + it , = 0 + 1 arctan( 2 Earnit ) + 3 arctan( 4 BVit ) + 5 + it , (EARN) (BV) (OHLN) (EARN) (BV) (OHLN).

Statistics reported in Panels A and B are coefcients on the dummy variables within the above models, where Dit is either rm age (zero for 3 years old or less) or new economy rm. Panel A presents those on rm age, whereas Panel B presents those on new economy rms. *, **, *** represent statistical signicance at the 10, 5 and 1% levels, respectively.

coefcients in Panel B indicate that accounting information is less relevant for non-new economy rms, particularly for earnings and book value information. Our results however, are not as pervasive as the US evidence (Core et al., 2003). In addition, controlling for nonlinearities appears to mitigate both the age and new economy effects, suggesting that age and new economy differences migjt be a symptom of such organisations having less permanence in their accounting information. For example, young rms would generally fall into the small rm category, which have been shown to have less persistence in their earnings numbers. The question then is whether to control for nonlinearities or The Authors

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size or rm age. On the basis of our analysis the answer is to control for nonlinearities when examining the value relevance of accounting information in the Australian context. 3.4.4. Loss-making rms As a nal test, Core et al. (2003) include a dummy variable to control for loss making rms on the basis that prior literature has found differences in the valuation of loss and protable rms. Accordingly, we checked our data for the distribution of loss-making rms and found that in the rst half of our sample (19741987) the average percentage of loss rms was 14.2 per cent, with 1983 having the lowest loss percentage of 8 per cent. The second half of the data had a much higher average percentage of losses at 30.57 per cent, with 1992 having 40 per cent losses. We reran our regressions separately for losing and protable rms, and also with a dummy variable on the explanatory coefcients. For the linear models there was little difference in R2, but the dummy on protable rms was positive for only 1 year in the rst half of the data for all the price models (1981), but between 5 and 6 years in the last half. There was no signicant impact on the nonlinear models. 4. Summary and Conclusions This paper extends the US research that addresses the declining value relevance debate, using Australian data. We undertake methodological renements that involve controlling for transitory items using nonlinear regressions and adjusting for possible stock market inefciencies. Our initial linear regressions replicate and support the US results of declining value relevance. We then determine that nonlinearities and stock market inefciencies have increased over time and make adjustments for these effects. These adjustments signicantly improve the explanatory power of the earnings response coefcients. Moreover, the predictive power (R2) increases after adjusting for nonlinearity but not after a market inefciency adjustment. Results signal an intertemporal increase in temporary earnings components combined with a more volatile stock market. Further tests reveal that results were not driven by increased leverage, new rms, new economy rms, or loss making rms. We also found evidence that the earnings relevance for small rms declined in the later research period. This decline, however, was a far higher level and might well be a reversion back to economy-wide norms caused by increased analyst interest and/or a greater sophistication of investors. Finally, there is no evidence of a decline in the value relevance of the balance sheet. In summary, we conclude that: (i) the value relevance of conventional (core) accounting earnings have not signicantly declined over time; (ii) book values do not have as high a predictive power as earnings and are lower than in comparable studies in the USA (iii) the nature of the relationship with stock The Authors

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prices has changed such that a linear model does not fully abstract the association; and (iv) the use of nonlinear regressions provides a robust control. That is, conventional accounting information has not become less value relevant, there is simply a more complex contemporary nancial environment. Our research is informative for nancial analysts in Australia who wish to determine how to extract the most relevant accounting data for rm valuation. In a global sense, our results also hint that the relative value relevance in different countries might oscillate between earnings and balance sheet items (as they may well do for different industries). Hence, in our view, calls for radical (and expensive) changes to the accounting system from an income approach to a balance sheet approach are premature without the assistance of further international research. References
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