Empirical evidence of the effect of European accounting differences on the stock market valuation of...

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Empirical evidence of theeffect of European accountingdifferences on the stock marketvaluation of earnings and bookvalueMiguel Arce a & Araceli Mora aa Universitat de ValènciaVersion of record first published: 10 Nov 2010.

To cite this article: Miguel Arce & Araceli Mora (2002): Empirical evidence of the effectof European accounting differences on the stock market valuation of earnings and bookvalue, European Accounting Review, 11:3, 573-599

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The European Accounting Review 2002, 11:3, 573–599

Empirical evidence of the effect of Europeanaccounting differences on the stock marketvaluation of earnings and book value

Miguel Arce and Araceli Mora

Universitat de Valencia

Manuscript first received: May 2000. Manuscript accepted: November 2001.

ABSTRACT

Recently, a new dimension has been added to research in accounting harmonization bystudying the effects of accounting practices and regulations on share price and returnmovements. Although there is an agreement of mutual recognition in the Europeanstock markets of financial statements adapted to the directives, the differences betweenthe European countries are still great. The objective of this study is to investigate thevalue relevance of alternative accounting measures (earnings and book value)constructed under different accounting systems in Europe. We investigate the differ-ences in accounting practices through the relationship between earnings and bookvalue, and the stock market value of the firm. The aim of the study is to answer thefollowing three questions: (1) Are there systematic differences in value relevancebetween earnings and book value across the different European accounting systems?(2) Do book value and earnings convey different information to stock valuation? (3) Areaccounting numbers more value relevant in those countries traditionally orientated tomarket investors? The sample consists of listed firms from eight European countries(Belgium, France, Germany, Italy, The Netherlands, Switzerland, Spain and the UK).The results obtained could be helpful for the decisions of institutional regulatory bodiessince we find evidence of significant differences in the stock market valuation ofaccounting data not explained by the composition of the sample or macroeconomicfactors, but mainly by the differences in reporting philosophies across Europe.

1. INTRODUCTION

Several authors1 have proposed different classifications of the accounting systems

throughout the world taking into account different factors of influence. Tradi-

tionally, the European Union countries have been divided into two groups

depending on their finance, legal and tax systems. According to many

Address for correspondence

Universitat de Valencia, Facultat d’Economia, Avda. dels Tarongers, s=n, Valencia

46071, Spain. Fax: þ34-96-3828287. E-mails: [email protected] and [email protected]

Copyright # 2002 European Accounting Association

ISSN 0963-8180 print=1468-4497 online DOI: 10.1080=09638180220125616

Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA

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researchers, countries with a code-based legal system and with a business

financing structure that is primarily based on banking, are characterized by a

strong tax influence on accounting and, therefore, by the presence of govern-

mental rather than professional regulatory bodies. On the other hand, countries

with a system based on common law and with a well-developed capital market

have issued accounting rules independently from tax rules, under the auspices of

professional bodies. Under these circumstances, we make the hypothesis that

the investor-orientated legislation in common-law countries versus the creditor

orientation of code-law countries will imply a higher value relevance of earnings

than book value in common-law countries and vice versa. For the same reasons,

we test the hypothesis that accounting information is more value relevant in

market-orientated countries than in creditor-orientated countries.

In summary, this study considers the value relevance of financial statements

across European accounting systems. We explore two generic accounting vari-

ables: book value and earnings. We focus on both accounting variables for two

reasons. First, a central feature of the accounting systems in the world is that the

financial statements of companies are comprised of at least two components,

namely a balance sheet and an income statement. Second, book value and

earnings are the key variables in the theoretical accounting valuation model

developed by Ohlson (1995). The sample consists of listed firms from eight

European countries (Belgium, France, Germany, Italy, The Netherlands, Switzer-

land, Spain and the UK).

Should we find that there are differences in the value relevance of accounting

information due to differences in accounting rules, then there would be an

empirical justification for the harmonization process in Europe. But if, on the

other hand, this association of accounting information with stock prices is

predictable, or if it depends on institutional or economic factors, then it could

be said that a greater effort in the harmonization process by the regulatory bodies

would be unnecessary.

The paper is organized as follows: in the second section, we analyse previous

research. The following sections present the empirical analysis describing the

hypotheses, the research design and the results, respectively. Finally, we present

our conclusions and discuss the implications of the study in the closing section.

2. PREVIOUS LITERATURE

In recent years a number of empirical studies have investigated the stock market

valuation of accounting data in an international context, with a particular focus on

both the USA, the UK, France and Germany. As Pope (1993) pointed out, ‘when

the results of these studies reflect different information content of accounting data

under different GAAP, this helps to justify the process of harmonisation’.

Joos and Lang (1994) investigate the effect of differences in accounting in

France, Germany and the UK using regressions as methodology. They find

evidence of significant differences in both financial characteristics (ratios) of the

574 The European Accounting Review

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companies and the stock market valuation of accounting measures not explained

either by the composition of the sample or by macroeconomic factors.

Joos (1997) uses the EBO model to investigate differences in value relevance

of the different European accounting systems, represented by Germany, France

and the UK. Joos (1997) argues differences in the institutional characteristics of

these countries to structure the following predictions:

(a) The value relevance of earnings will be higher than that of book value in

the UK (because of the importance of common shareholders) and vice

versa in both Germany and France.

(b) The value relevance of earnings and book value together (measured by R2)

will be higher in the UK than in France and Germany.

(c) The multiples of both book value and earnings will be higher for both

France and Germany than for the UK because of differences in

conservatism.

Following Joos (1997), conservatism plays an important role in the theoretical

Feltham and Ohlson (1995) setting. This model predicts that conservatism will

be reflected in the multiples of the model applied to financial statements

variables: conservatively measured items receive higher valuation multiples.

The idea of ‘accounting conservatism’ used by Joos (1997) to make his

prediction is based on the concept of ‘conservatism’ used by Belkaoui (1985:

239). He claimed that the term ‘accounting conservatism’ implied that ‘prefer-

ably the lowest values of assets and revenues and the highest values of liabilities

and expenses had to be reported’. Debtholders and other creditors demand timely

information about bad news because the option value of their claims (Smith,

1979) is more sensitive to a decline than to an increase in firm value. For this

reason Continental countries, with financial institutions as the main providers of

finance, have been traditionally considered more conservative than Anglo-

American countries.

Thus, the prediction of the hypothesis is therefore that the coefficients on

earnings and book value in a regression of price on both accounting variables are

larger in the Continental system than in the Anglo-Saxon system.

The empirical design uses regressions of price on annual earnings and book

values, with hypothesis tests on regression R2 statistics and estimated coefficients.

Results from the tests are not entirely consistent with his predictions. The results

obtained by Joos (1997) are the following:

(a) Earnings are more highly value relevant (R2) than book value in the UK

regression, although the opposite relation does not hold for Germany or

France, where the value relevance of earnings and book values is not

statistically distinguishable.

(b) The value relevance of accounting information (R2) is higher in the case

of France than in the UK and Germany.

European accounting differences on the stock market 575

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(c) The estimated coefficients on book values are reliably higher in Germany

and France than in the UK, but the earnings multiples estimated in the

price regressions are not reliably different in the UK than in the other two

countries.

More recently, King and Langli (1999) use the same methodology to test

similar hypotheses with three European countries: the UK, Germany and Norway.

They make two hypotheses:

(a) Conservative German accounting practices will result in lower value

relevance for earnings and book value together than in Norway and

the UK.

(b) Book value explains more than earnings in Germany but less in the UK

and Norway.

Their results confirm the previous hypotheses.

In an international context, we want to emphasize that the previous studies

(Joos and Lang, 1994; Joos, 1997; King and Langli, 1998) have tried to analyse

the differential effect of accounting conservatism across countries using associa-

tion models but that their results are confusing. Specifically, Joos (1997) was

looking for a consistent understatement of accounting earnings as well as of

book value and in most cases he did not find any evidence of this. It is important

to point out again that while it is possible to consistently report low values of the

book value of the firm, it is not possible to do the same with accounting

earnings. It has been erroneously accepted than Continental countries consis-

tently understated accounting earnings. It has been demonstrated that this

argument is not correct, often citing the example of the German company

Daimler-Benz (see Ball, 1998), that in 1993 reported a positive income of

DM615 million, that reconciled to US GAAP became a loss of DM1,839

million. As King and Langli point out, the differences in the relative incremental

information content of book value and earnings per share both within and across

the countries do not conform to simple stories based on conservatism and clean

surplus violations.

In summary, previous evidence about the differences in the relevance of

accounting information across Europe is scarce. Conclusions about the differ-

ences between the two traditional accounting systems have been obtained

analysing the behaviour of companies from no more than three countries, and

the authors fail in testing some of their hypotheses.

3. SAMPLE SELECTION, HYPOTHESIS DEVELOPMENTAND RESEARCH DESIGN

The research design and the organization of the analyses are based on three

accounting themes related to the value relevance of earnings and book value: the

relative importance of book value and earnings for valuation, the incremental


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value relevance of accounting numbers and the differences in value relevance of

accounting information across Europe. The objective is to answer the following

three questions: (1) Are there systematic differences in value relevance between

earnings and book value across the different European accounting systems?

(2) Do book value and earnings convey different information to stock valuation?

(3) Are accounting numbers more value relevant in the countries traditionally

orientated to market investors?

The methodology followed in the present paper to test our hypotheses is based

on the so-called EBO model. This model formalizes an explicit association

between stock prices and accounting numbers (earnings and book value). The

model is based on the dividend discounting model and the clean surplus relation.

So throughout the share prices we are able to assess the value relevance of both

earnings and book value and also their differences.

The sample

As we have mentioned before, our study focuses its attention on the eight

countries that represent the most important stock markets in Europe. So

companies from Belgium, France, Germany, Italy, The Netherlands, Switzerland,

Spain and the United Kingdom compose the sample. The models are estimated

from financial statements published over the fiscal years 1990–98. The data are

extracted from the Extel Financial Company Analysis database, last updated in

May 2001. The sample excludes financial companies, property firms and

investment trusts. An additional requirement of the data is that the included

firms have to be active companies, so we only consider firms disclosing positive

sales revenue. To control for extreme values, we remove observations that are in

the top and bottom percentiles of the variables. Selection process yields 22,436

firm=year=country observations.

In order to develop the hypotheses, we have considered the traditional

classification of the European countries into two accounting systems: the

Continental system (code-law countries) and the Anglo-American system

(common-law countries). The Netherlands, in spite of being a code-law country,

has been typically included in the Anglo-American group due to the characteristics

of its accounting system. So, for our purpose, we consider the UK and The

Netherlands in the Anglo-American group and Belgium, France, Germany, Italy,

Switzerland and Spain in the Continental group. Though we are aware that this

traditional classification of the European accounting systems does not accurately

reflect their complexity, mainly after the recent developments in accounting over

the last decade, we consider, as most researchers do, that the distinction of these

two groups is still necessary at least to develop hypotheses. In spite of recent

studies showing that some of the assumptions can be excessively simplistic, these

are, in the main, when referring to the accounting practices of listed companies.


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Hypotheses and methodology

The hypotheses are examined applying an explanatory power test, R2-based

analysis. We use the following model:

Pit ¼ a0 þ a1BVit þ a2Xit þ e1it ð1Þ

where Pit is the share price of company (i) at balance sheet date (t), BV is the book

value, and X the accounting earnings in a per share basis.

The variables are computed as follows:

� Price ðPÞ is share price at period end ðmkt:shpcÞ

� Book value (BV ) of common shares is defined as the shareholders’ equity less

share capital plus ordinary shares and divided by the number of shares at the

balance sheet date: ½ðeq� eq:sþ eq:s:osÞ=mkt:nsh�.

We use two alternative definitions of earnings, namely net income and earnings

before extraordinary and exceptional items. We use these two measures of

earnings to test our hypotheses as both have been used previously in the literature

about the relevance of accounting information. It is important to consider that net

income incorporates transitory components that could mislead investors in order

to value=when valuing shares (Collins et al., 1997; Hand and Landsman, 1999;

Barth et al., 1999). The second definition (earnings before extraordinary items)

better captures the permanent component of earnings.

However, in the present study, it is important to point out that the definition of

extraordinary items is not coincident in all the countries in the sample and this

fact could affect the results (Pope and Walker, 1999). For this reason, we are

going to consider both definitions and then compare the results.

Net income (NI ) is the net income divided by the number of shares at the

balance sheet date (ni=mkt.nsh). Earnings before extraordinary and exceptional

items (E ) are calculated as net income less extraordinary items and exceptional

charges in a per share basis [(ni7 xt7 xc)=mkt.nsh].

Table 1 reports summary descriptive statistics for the different countries in the

sample.

The relative importance of book value versus earnings for valuation

In relation to the first question: Are there differences in value relevance between

earnings and book value across Europe? We make the following prediction based

entirely on the difference in the providers of finance across the two accounting

systems considered.

Creditor orientation leads to focus on the balance sheet. As a consequence,

companies from Continental countries have to opt for the method that provides


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Table

1D

escr

ipti

ve

stat

isti

cs

NMean

Std.dev.

Min

.Q1

Median

Q3

Max.

Belgium

P1

55

71

27

.09

71

73

.95

60

.77

53

1.8

67

64

.50

51

52

.32

11

,54

1.9

40

NI

55

77

.83

02

3.6

50

�3

1.4

70

0.9

42

3.3

39

9.5

41

47

2.2

19

E5

57

6.6

80

12

.20

8�

40

.84

00

.83

93

.18

38

.91

38

3.5

24

BV

55

79

8.4

99

18

2.5

74

�0

.86

31

9.3

50

44

.01

01

01

.12

71

,62

1.8

50

P1=P

05

57

1.0

33

0.3

18

0.0

28

0.8

60

1.0

29

1.2

12

2.6

35

NI=P

05

57

0.0

43

0.1

40

�1

.33

10

.02

00

.06

10

.09

00

.51

0BV=P

05

57

0.7

87

0.5

41

�0

.10

00

.41

70

.67

21

.09

74

.95

4

France

P1

3,0

11

63

.37

46

8.6

86

0.8

50

20

.54

34

3.5

32

78

.20

95

38

.00

9NI

3,0

11

3.2

58

6.6

37

�3

6.1

68

0.7

14

2.2

79

4.7

47

12

1.8

94

E3

,01

13

.19

45

.35

5�

35

.19

90

.66

22

.23

54

.70

13

8.3

06

BV

3,0

11

41

.55

24

3.6

46

0.0

72

13

.54

82

6.5

79

52

.65

83

02

.94

8P

1=P

03

,01

11

.04

10

.39

20

.10

00

.79

90

.99

71

.23

63

.35

6NI=P

03

,01

10

.04

20

.12

1�

1.4

28

0.0

22

0.0

55

0.0

87

0.9

73

BV=P

03

,01

10

.79

00

.53

80

.02

60

.40

60

.66

31

.03

83

.98

5

Germany

P1

2,5

54

13

1.0

13

11

4.3

95

4.4

96

50

.24

41

01

.91

81

80

.54

89

42

.57

2NI

2,5

54

3.9

88

11

.22

1�

85

.04

50

.40

83

.08

87

.89

72

01

.25

1E

2,5

54

3.3

14

10

.18

2�

98

.97

10

.21

92

.82

77

.63

84

3.3

85

BV

2,5

54

58

.81

14

7.1

50

�2

.38

52

4.5

42

48

.40

68

0.3

28

33

5.2

32

P1=P

02

,55

41

.47

42

.08

20

.43

40

.88

21

.03

41

.26

13

0.5

96

NI=P

02

,55

40

.01

80

.16

9�

2.8

17

0.0

06

0.0

37

0.0

66

1.7

41

BV=P

02

,55

40

.55

90

.37

1�

0.0

41

0.3

15

0.4

80

0.6

94

3.2

35

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Table

1(continued

)

NMean

Std.dev.

Min

.Q1

Median

Q3

Max.

Italy

P1

95

02

.23

32

.13

90

.03

80

.65

91

.57

53

.26

21

9.5

89

NI

95

00

.12

00

.24

7�

1.6

45

0.0

07

0.0

88

0.2

28

0.9

97

E9

50

0.1

04

0.2

34

�1

.28

9�

0.0

07

0.0

71

0.2

13

1.1

08

BV

95

01

.87

91

.73

8�

0.0

57

0.7

32

1.3

09

2.6

46

14

.98

3P

1=P

09

50

1.0

09

0.3

92

0.1

68

0.7

65

0.9

49

1.1

82

4.7

88

NI=P

09

50

0.0

22

0.1

97

�2

.79

20

.01

10

.05

20

.09

61

.10

1BV=P

09

50

0.9

95

0.5

56

�0

.10

60

.59

20

.88

11

.29

04

.24

6

Netherlands

P1

1,1

29

26

.80

62

6.1

37

0.8

35

10

.98

91

8.7

34

33

.19

72

57

.40

9NI

1,1

29

2.1

45

3.0

54

�2

5.9

16

0.7

08

1.4

58

2.9

33

30

.67

0E

1,1

29

2.2

18

2.7

38

�1

0.1

03

0.7

19

1.4

68

2.9

08

30

.67

0BV

1,1

29

16

.76

21

9.9

38

0.2

84

5.0

43

10

.38

42

1.9

03

19

7.1

03

P1=P

01

,12

91

.04

30

.38

50

.07

90

.83

01

.02

21

.23

14

.65

2NI=P

01

,12

90

.07

70

.09

2�

0.5

79

0.0

43

0.0

84

0.1

16

0.6

42

BV=P

01

,12

90

.66

00

.43

10

.01

10

.34

10

.57

80

.91

63

.07

2

Spain

P1

84

11

4.9

37

14

.40

50

.18

15

.20

61

0.0

92

21

.16

18

9.9

98

NI

84

10

.91

91

.55

3�

9.4

03

0.2

46

0.6

40

1.5

40

10

.82

5E

84

10

.92

61

.48

5�

4.6

93

0.1

82

0.6

01

1.4

74

10

.53

9BV

84

11

1.0

34

9.3

88

�0

.85

44

.18

98

.20

11

5.3

46

66

.48

5P

1=P

08

41

1.0

03

0.4

53

0.0

19

0.7

19

0.9

60

1.2

23

4.1

09

NI=P

08

41

0.0

41

0.9

09

�4

.16

80

.02

70

.06

20

.09

42

4.8

76

BV=P

08

41

0.8

80

0.6

06

�2

.21

40

.48

30

.76

41

.14

13

.97

6

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Switzerland

P1

1,2

73

50

2.9

78

61

8.6

18

5.6

01

12

6.9

67

31

0.4

30

61

5.9

45

5,8

66

.04

0NI

1,2

73

24

.84

05

5.1

51

�5

37

.34

34

.49

11

5.5

62

37

.26

94

02

.29

9E

1,2

73

27

.05

14

9.3

54

�3

03

.02

24

.42

91

5.7

23

37

.86

53

82

.75

9BV

1,2

73

38

4.4

47

50

2.5

20

�2

1.4

63

87

.65

42

13

.89

64

84

.78

23

,72

5.6

4P

1=P

01

,27

31

.04

50

.44

50

.08

50

.80

71

.00

31

.22

04

.76

5NI=P

01

,27

30

.03

70

.17

5�

3.1

87

0.0

21

0.0

57

0.0

89

0.9

67

BV=P

01

,27

30

.89

20

.82

8�

0.3

30

0.4

21

0.7

19

1.1

42

15

.89

8

UK

P1

12

,12

11

.98

02

.12

00

.01

80

.51

51

.27

02

.71

02

5.0

00

NI

12

,12

10

.11

00

.22

6�

2.4

21

0.0

10

0.0

86

0.1

89

5.8

66

E1

2,1

21

0.1

28

0.1

77

�0

.57

50

.02

00

.09

30

.19

52

.75

0BV

12

,12

11

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81

.31

8�

0.4

79

0.2

88

0.6

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1.3

18

21

.37

8P

1=P

01

2,1

21

1.0

65

0.5

36

0.1

19

0.7

49

1.0

00

1.2

68

7.4

67

NI=P

01

2,1

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0.0

21

0.3

41

�1

5.5

01

0.0

20

0.0

64

0.0

97

11

.73

2BV=P

01

2,1

21

0.6

70

0.7

52

�4

.34

80

.29

90

.52

20

.86

92

5.9

72

Notes:

Sam

ple

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from

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over

19

90

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or

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iable

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two

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eme

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firm

s=yea

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ith

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ues

for

on

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rm

ore

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ed.

All

the

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ute

din

po

und

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erli

ng

.P

ersh

are

val

ues

are

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ted

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ng

the

num

ber

of

outs

tandin

gco

mm

on

shar

es.

The

countr

ies

are

list

edin

alphab

etic

alord

er.

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more protection to creditors, even if it means distorting or reducing the value

relevance of earnings because of the regulation. This explains, for example, why

they do not record unrealized foreign exchange gains. In contrast to the

Continental countries, the predominance of the equity financing system in the

UK and The Netherlands leads to an important information role of financial

statements for investors and consequently the investor orientation of this

accounting system. On the other hand, certain accounting methods in the UK

system might introduce noise in the measurement of book value.2 Under the

going concern assumption, we expect that earnings will be more value relevant

than book value in the UK and The Netherlands. In summary, in Continental

countries, book value is more value relevant than earnings, while in The

Netherlands and the UK earnings are more value relevant than book value.

In order to test the hypothesis we decompose model (1) into two models that

consider the individual value relevance of book value and earnings. The models

considered are derived from model 1:

Pit ¼ b0 þ b1BVit þ e2it ð2Þ

Pit ¼ g0 þ g1Xit þ e3it ð3Þ

The value relevance of the book value and earnings separately is measured with

the R2’s in models (2) and (3). Then we apply the Vuong test3 to contrast the

statistical differences in R2 between models with same dependent variable (Pit)

and same sample but different independent variables (BVit and Xit). A description

of this test is presented in the Appendices. This test is based on a likelihood ratio

testing whether the residual variances of both models are equal. It informs about

the differences in value relevance of book value and earnings measured by R2.

The Vuong test compares the R2 from the earnings regression (3) directly to the

R2 of the book value regression (2). But, it must be taken into account that it does

not make any statement about the possible incremental value relevance of book

value and earnings, and thus how these R2 compare to the R2 of the regression on

both earnings and book value (1). To do that we compute the incremental R2 of

both earnings and book value and test the statistical significance of both measures

using a two-step regression and t-test.

The two tests presented above are complementary. The Vuong test answers the

question: what variable is more value relevant? The ‘two-step t-test’ indicates if

book value (earnings) conveys different information than earnings (book value).

In reference to this test Joos (1997: 83) states:

It is possible that the t tests indicate that both earnings and book value have incrementalexplanatory power for price but that the Vuong test does not reject the null equalityof R2. This is because the Vuong test does not differentiate between the components ofeach R2, whereas the t test strictly focuses on the incremental R2.

Both these tests have been used in other accounting papers such as Joos (1977),

King and Langli (1998) and Francis et al. (2001).


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The incremental value relevance of book value and earnings

In the previous section, we have shown how to ascertain which accounting

magnitude is more value relevant, but not if they convey different information to

explain market values. Now we want to answer the question: Do book value and

earnings convey different information to stock valuation? In model (1) we can

distinguish between the R2 that is explained exclusively by earnings or book

value, and that explained jointly by both accounting numbers. We are able to

distinguish if earnings and book value convey different information to explain

market values by decomposing the R2 of model (1) as:

R2ð1Þ ¼ R2

ix þ R2ibv þ R2

c

where R2ibv is the incremental book value R2 on earnings, R2

ix is the incremental

earnings R2 on book value, and R2c is the common R2 to book value and earnings,

R2ibv ¼ R2

ð1Þ � R2ð3Þ

The incremental explanatory power of book value is the total explanatory power

of book value and earnings less the explanatory power of earnings alone:

R2ix ¼ R2

ð1Þ � R2ð2Þ

The incremental explanatory power of earnings is the total explanatory power of

book value and earnings less the explanatory power of book value alone:

R2c ¼ R2

ð2Þ þ R2ð3Þ � R2

ð1Þ

The explanatory power common to book value and earnings is the total

explanatory power of book value and earnings less the incremental explanatory

power of book value and the incremental explanatory power of earnings.

The incremental R2 of book value (earnings) on earnings (book value) is

computed as the difference between the R2 of model 1 and the R2 of model 2

(model 3). This test is carried out in similar papers such as Joos (1997) and King

and Langli (1998).

The differences in value relevance of accounting information acrossEurope

The third question we address is related to the cross-country differences in value

relevance in the European context: Are accounting numbers more value relevant

in the countries traditionally orientated to market investors? Following previous

evidence (Joos, 1997; King and Langli, 1998) this has been analysed through the

relation between financial statement variables and stock prices. Our hypothesis is


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related to R2: The value relevance of accounting information, earnings and book

value, is higher in terms of R2 in investor-orientated countries than in Conti-

nental countries.

In this case, we have to consider that we are comparing R2 between different

samples. Brown et al. (1999) show that the use of R2 to measure value relevance

could be inappropriate when we make comparisons between different samples

using levels regressions like model (1). This is due to the existence of scale

effects that increase R2, and these effects increase the scale factor’s coefficient of

variation. Although the comparison of R2’s is appropriate when there are no

significant differences in the scale factor’s coefficient of variation across samples,

a previous analysis of the data shows large differences across the countries under

study. Following Brown et al. (1999) we solve this problem deflating each

variable in model (1) by a proxy for the unobservable scale factor. We use the

share price at the beginning of the period to proxy for the scale factor.4 Then

model (1) and subsequent models are estimated deflating by Pit�1.

Once considered the scale effects in the way Brown et al. (1999) do, to

compare the statistical differences between R2’s across different samples, we

apply a test based on the statistical properties of R2 (Cramer, 1987). This test is

useful to compare R2 across different samples. This test procedure was previously

applied in accounting papers by Joos and Lang (1994), Harris et al. (1994) and

Joos (1997). The test compares R2 from two different regressions and is based on

the following Z-statistic:

Z ¼R2

1 � R22ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

s2R2

1

þ s2R2

2

q

R21 and R2

2 are the R2 from regressions for countries 1 and 2 that are being compared

and s2ð�Þ its variance. In the empirical domain, we approximate them based on the

Cramer (1987: 256) developments of mean and variance of R2, the estimation is

based on summations over 150 terms. Under the null hypothesis of no difference

between both R2, this Z-statistic is approximately standard normal in large samples.

One caveat of the test is that it assumes that both samples are independent. In our

opinion this assumption could be sustainable under our analysis.

We use per share values to mitigate the effect of heteroscedasticity (Barth and

Kallapur, 1996), even though we estimate the t-statistics using the White (1980)

heteroscedasticity-consistent standard errors.

Sensitivity analysis

In the present study, we assume that the economic conditions under which

companies operate in Europe are very similar, so the differences in the

coefficients and the association measures tested in the hypotheses are due to

the differences in the accounting systems. Notwithstanding, we carry out some


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additional tests to confirm whether differences in value relevance will continue to

hold after taking into account within-country cross-sectional factors.

The within-country factors considered are related to size, growth and stock

market factors. Market capitalization proxy for company size, while growth in sales

proxy for the company growth. The stock market factors contemplated are the

book–market ratio and price–earnings ratio. The introduction of these factors in the

analysis has been done by splitting the sample in two groups for each factor using

the median of each proxy as cut-off. Then the regressions have been run again.

After repeating the analyses taking into account these within-country factors,

we predict that the cross-country differences in the association between market

value and the accounting measures will remain unaffected.

4. EMPIRICAL RESULTS

The relative value relevance of book value and earnings

As stated above, the first hypothesis claims that the relative importance of the

variable ‘book value’ in explaining share prices, measured by R2, is higher in

Continental countries than that of the variable ‘earnings’. On the other hand, the

relative importance of ‘earnings’ is higher than ‘book value’ in the UK and The

Netherlands. To test the significance of this difference we compare R2’s in models

(2) and (3) using the Vuong test to non-nested models.

The results of estimated regressions are shown in Table 2 and the Vuong test

t-statistics are presented in Table 3. The results in Table 3 show the comparison of

the value relevance of book value and the two measures of earnings (earnings before

extraordinary and exceptional items, and net income). The results are similar using

both measures of earnings. The differences in the concept of extraordinary items

existing between the countries do not significantly affect the conclusions about the

relative value relevance between book value and the earnings measure. There is an

exception in the case of the UK, where earnings before extraordinary items is more

relevant than book value, but book value is more relevant than net income.

In countries where credit institutions play a more important role, which follow

the Continental system, the adjusted R2 in model (2) (earnings) is lower than in

model (3) (book value). In France, however, earnings are more relevant. Never-

theless, when the significance of this difference is considered, the results for

Belgium and Italy are not statistically significant.

When the UK and The Netherlands are considered, earnings before extra-

ordinary items is more relevant than book value. This can be explained by the

market influences in the financing policy of companies. These results can be

interpreted as the income statement playing a more important role in valuation

than the balance sheet in the UK and The Netherlands.

The comparison of value relevance of the two earnings measures shows that

net income relevance is consistently lower than the other earnings figure in terms

of R2 (Table 2). This is especially remarkable in the cases of the UK and The


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Table 2 Estimated regressions of models (1), (2) and (3)

Intercept E=P0 NI=P0 BV=P0 R2 adjust.

Belgium 0.861 0.839 0.170 0.139(0.000) (0.052) (0.043)0.878 0.530 0.167 0.138

(0.000) (0.053) (0.044)0.994 0.858 0.057

(0.000) (0.054)1.009 0.555 0.058

(0.000) (0.053)0.897 0.172 0.084

(0.000) (0.044)

France 0.898 1.128 0.116 0.120(0.000) (0.019) (0.034)0.912 0.816 0.120 0.103

(0.000) (0.022) (0.034)0.985 1.225 0.096

(0.000) (0.018)1.003 0.898 0.077

(0.000) (0.020)0.924 0.148 0.041

(0.000) (0.028)

Germany 1.242 0.380 0.406 0.005(0.000) (0.219) (0.085)1.242 0.047 0.413 0.005

(0.000) (0.440) (0.084)1.468 0.447 0.000

(0.000) (0.194)1.472 0.116 0.000

(0.000) (0.359)1.242 0.414 0.005

(0.000) (0.083)

Italy 0.844 0.381 0.162 0.083(0.000) (0.060) (0.043)0.849 0.371 0.153 0.091

(0.000) (0.053) (0.046)1.005 0.418 0.032

(0.000) (0.056)1.000 0.428 0.045

(0.000) (0.047)0.840 0.170 0.057

(0.000) (0.041)

Netherlands 0.841 1.602 0.110 0.100(0.000) (0.036) (0.075)0.882 0.994 0.127 0.090

(0.000) (0.039) (0.064)0.897 1.811 0.086

(0.000) (0.031)0.956 1.126 0.072

(0.000) (0.034)


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Table 2 (continued)

Intercept E=P0 NI=P0 BV=P0 R2 adjust.

0.927 0.175 0.037(0.000) (0.047)

Spain 0.856 0.091 0.165 0.053(0.000) (0.159) (0.048)0.853 �0.001 0.169 0.049

(0.000) (0.481) (0.048)1.001 0.120 0.005

(0.000) (0.128)1.002 0.021 0.001

(0.000) (0.220)0.854 0.169 0.050

(0.000) (0.047)

Switzerland 0.911 0.503 0.126 0.082(0.000) (0.052) (0.036)0.897 0.534 0.144 0.099

(0.000) (0.041) (0.032)1.022 0.525 0.028

(0.000) (0.051)1.029 0.439 0.029

(0.000) (0.051)0.931 0.129 0.056

(0.000) (0.036)

UK 0.967 0.808 0.083 0.056(0.000) (0.016) (0.025)0.990 0.113 0.107 0.030

(0.000) (0.040) (0.019)1.016 0.933 0.044

(0.000) (0.013)1.062 0.144 0.008

(0.000) (0.031)0.988 0.114 0.025

(0.000) (0.018)

Notes:

The estimated regressions of models (1), (2) and (3), based on ordinary least squares. Independent

variables are earnings before extraordinary and exceptional items per share (E ), net income (NI ) and

book value (BV ). Variables in the model are deflated by the share price at the beginning of the period.

R2 adjust. is the estimated R2 adjusted to the degrees of freedom and N is the number of observations.

Data as defined in Table 2. Figures in parentheses represent the t-test. The standard errors are

calculated using the White (1980) heteroscedasticity-consistent variance–covariance matrix.

Netherlands, while in Germany there are no differences. These results are

consistent with the fact that net income incorporates transitory components,

which are less relevant for the market. We want to emphasize the fact that in the

case of the UK and The Netherlands this difference is higher than in the case of

Continental countries. This may be due to the fact that the concept of extraordinary


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items is wider in Continental countries, and so it is easier that they include

permanent components than in the case of the UK and The Netherlands.

The incremental value relevance of book value and earnings

The results about incremental explanatory power of fundamental variables shown

in Table 4 are very much in line with expectations. In the UK and The

Netherlands both earnings figures have statistical significant incremental expla-

natory power over book value, but at the same time book value has significant

incremental explanatory power over earnings. This is more evident when earnings

before extraordinary and exceptional items are considered than in the case of net

income due to the reasons stated above.

On the other hand, in Continental countries the book value has a significant

incremental explanatory power over earnings. Nevertheless, earnings also add

relevant information in all countries except Germany, and Spain when net income

Table 3 Vuong test of relative value relevance of earnings and book value

Independentvariable inmodel (2)

Independentvariable inmodel (3)

Sig.

Belgium E=P0 < BV=P0 (0.708)NI=P0 < BV=P0 (0.699)

France E=P0 > BV=P0 (0.000)NI=P0 > BV=P0 (0.008)

Germany E=P0 < BV=P0 (0.000)NI=P0 < BV=P0 (0.000)

Italy E=P0 < BV=P0 (0.143)NI=P0 < BV=P0 (0.494)

Netherlands E=P0 > BV=P0 (0.019)NI=P0 > BV=P0 (0.065)

Spain E=P0 < BV=P0 (0.006)NI=P0 < BV=P0 (0.001)

Switzerland E=P0 < BV=P0 (0.059)NI=P0 < BV=P0 (0.083)

UK E=P0 > BV=P0 (0.000)NI=P0 < BV=P0 (0.000)

Notes:

The Vuong test tests for differences in R2 between models (2) and (3) shown in

Table 2. Independent variables in model (2) are earnings before extraordinary and

exceptional items (E ) and net income (NI ). Sig. indicates the probability to accept

the null hypothesis of equality of R2’s.


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Table 4 R2 decomposition of model (1) and two-step regression t-test

R2 Sig.

BelgiumIncremental R2 of E=P0 on BV=P0 0.055 (0.000)Incremental R2 of BV=P0 on E=P0 0.082 (0.000)Common R2 0.002

Total 0.139

Incremental R2 of NI=P0 on BV=P0 0.053 (0.000)Incremental R2 of BV=P0 on NI=P0 0.080 (0.000)Common R2 0.005

Total 0.138

FranceIncremental R2 of E=P0 on BV=P0 0.079 (0.000)Incremental R2 of BV=P0 on E=P0 0.025 (0.000)Common R2 0.016

Total 0.120


Total 0.103

GermanyIncremental R2 of E=P0 on BV=P0 0.000 (0.224)Incremental R2 of BV=P0 on E=P0 0.005 (0.000)Common R2 0.000

Total 0.005


Total 0.005

ItalyIncremental R2 of E=P0 on BV=P0 0.026 (0.000)Incremental R2 of BV=P0 on E=P0 0.052 (0.000)Common R2 0.005

Total 0.083


Total 0.091

NetherlandsIncremental R2 of E=P0 on BV=P0 0.062 (0.000)Incremental R2 of BV=P0 on E=P0 0.013 (0.000)Common R2 0.024

Total 0.100


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is considered. The results are more conclusive when earnings before extraordin-

ary and exceptional items are taken. These results can be interpreted as the

balance sheet playing a more important role in valuation than the income

statement in Continental countries, earnings also conveying additional informa-

tion to value shares, and vice versa.

Table 4 (continued)

R2 Sig.


Total 0.090

SpainIncremental R2 of E=P0 on BV=P0 0.003 (0.067)Incremental R2 of BV=P0 on E=P0 0.047 (0.000)Common R2 0.003

Total 0.053

Incremental R2 of NI=P0 on BV=P0 �0.001 (0.952)Incremental R2 of BV=P0 on NI=P0 0.048 (0.000)Common R2 0.002

Total 0.049

SwitzerlandIncremental R2 of E=P0 on BV=P0 0.026 (0.000)Incremental R2 of BV=P0 on E=P0 0.054 (0.000)Common R2 0.002

Total 0.082

Incremental R2 of NI=P0 on BV=P0 0.043 (0.000)Incremental R2 of BV=P0 on NI=P0 0.070 (0.000)Common R2

�0.014

Total 0.099

UKIncremental R2 of E=P0 on BV=P0 0.031 (0.000)Incremental R2 of BV=P0 on E=P0 0.013 (0.000)Common R2 0.013

Total 0.056


Total 0.030

Notes:

Two-step regression is used to test the incremental explanatory power of

earnings figures (E and NI ) over book value (BV ) and vice versa. Sig. indicates the

probability to accept the null hypothesis of equality of R2 to zero.


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The differences in the value relevance of accounting informationacross Europe

The third question concerns the differences in the value relevance of accounting

information across Europe. If we consider the R2’s for France, the UK and

Germany (see Table 2) the results are similar to those of Joos (1997). France

presents a higher R2 than the UK and Germany, and this last country shows the

lowest R2 for both measures of earnings. These results are consistently corrobo-

rated by the Cramer test results in Table 5.

When the earnings figure considered is earnings before extraordinary items,

then Belgium (0.139), France (0.116) and The Netherlands (0.100) show the

highest R2’s while Germany (0.005), Spain (0.053) and the UK (0.056) show the

lowest value relevance of accounting numbers. The results are very similar

when using net income as the independent variable. As Joos (1997), our

evidence does not confirm the hypothesis that the value relevance is higher in

the UK and The Netherlands than in the Continental countries (except in the

case of Germany).

Sensitivity analysis

As we stated above, we test the hypothesis that differences in value relevance

found in previous sections will continue to hold after taking into account within-

country cross-sectional factors (size, growth and stock market factors). Results

related to the first two questions, not reported here, confirm our previous results.

Thus, after controlling for within-country factors the value relevance of book

value is still higher in Continental countries than earnings. On the other hand, in

the UK and The Netherlands earnings are more relevant for valuation than book

value. Additionally, the incremental explanatory power of earnings on book value

found for all the countries under study remains invariant. The incremental value

relevance of book value on earnings, however, can only be sustained in

Continental countries.

Now we shall concentrate our comments on the results about international

value relevance differences of accounting numbers as a whole. Panel A of Table 6

shows pool regression results for model (1) when market capitalization is

considered as a proxy for size. Again we find similar patterns in R2 indicating

that size is not a determinant of cross-country differences in value relevance. The

same analysis has been repeated using growth in sales as a proxy for company

growth (Table 6, Panel B) obtaining similar results.

The stock market factors contemplated are book–market ratio (Table 6, Panel

C) and price–earnings ratio (Table 6, Panel D). Negative earnings are discarded

when the price–earnings ratio is considered because of problems with negative

denominators. When the book–market ratio determines the sample division, the

results are much in line with the previous ones, showing that Belgium exhibits the


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Table

5C

ram

erte

st

Belgium

France

Germany

Italy

Netherlands

Spain

Switzerland

Panel

A:Model

(1),independentvariables:

net

incomeandbookvalue

Fra

nce

(0.3

48

)G

erm

any

(0.052

)(0.018)

Ital

y(0

.35

2)

(0.4

54

)(0

.18

8)

Net

her

lan

ds

(0.3

23

)(0

.43

5)

(0.116

)(0

.50

3)

Sp

ain

(0.2

18

)(0

.27

9)

(0.3

02

)(0

.36

9)

(0.3

50

)S

wit

zerl

and

(0.3

80

)(0

.48

5)

(0.1

78

)(0

.52

3)

(0.5

30

)(0

.34

9)

UK

(0.087

)(0.041)

(0.109

)(0

.26

0)

(0.1

89

)(0

.59

1)

(0.2

45

)

Panel

B:Model

(1),independentvariables:

earningsbefore

extraordinary

andexceptionalitem

sandbookvalue

Fra

nce

(0.3

99

)G

erm

any

(0.051

)(0.009)

Ital

y(0

.32

5)

(0.3

75

)(0

.21

1)

Net

her

lan

ds

(0.3

54

)(0

.42

1)

(0.090

)(0

.44

2)

Sp

ain

(0.2

26

)(0

.24

7)

(0.2

85

)(0.406

)(0

.33

0)

Sw

itze

rlan

d(0

.32

7)

(0.3

77

)(0

.22

5)

(0.4

97

)(0

.44

1)

(0.4

11

)U

K(0

.14

8)

(0.076)

(0.006)

(0.3

88

)(0

.25

9)

(0.4

85

)(0

.39

7)

Notes:

The

Cra

mer

test

test

sfo

rdif

fere

nce

sin

R2

of

model

(1)

bet

wee

ntw

oco

untr

ies

bas

edon

esti

mat

edre

gre

ssio

ns

show

nin

Tab

le2

.N

um

ber

sin

par

enth

eses

indic

ate

the

pro

bab

ilit

yto

acce

pt

the

null

hypoth

esis

of

equal

ity

ofR

2’s

.

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Table 6 Estimated regressions of model (1)

Intercept E BV Adj. R2 N

Panel A: Market capitalizationBelgium Low 0.797*** 0.776*** 0.219*** 0.218 279

High 0.950*** 1.044*** 0.074* 0.063 278France Low 0.830*** 0.980*** 0.130*** 0.168 1,506

High 0.901*** 1.235*** 0.196*** 0.102 1,505Germany Low 1.164*** 0.054 0.437*** 0.010 1,277

High 1.262*** 1.707* 0.390* 0.004 1,277Italy Low 0.711*** 0.232*** 0.198*** 0.153 475

High 0.916*** 0.440*** 0.184*** 0.065 475Netherlands Low 0.749*** 1.629*** 0.152*** 0.193 565

High 0.896*** 1.348*** 0.152*** 0.061 564Spain Low 0.828*** 0.013 0.127*** 0.028 421

High 0.777*** 1.731*** 0.207*** 0.185 420Switzerland Low 0.825*** 0.346*** 0.162*** 0.128 637

High 0.956*** 0.818*** 0.113*** 0.071 636UK Low 0.900*** 0.623*** 0.083*** 0.070 6,061

High 0.939*** 1.055*** 0.238*** 0.061 6,060

Panel B: Growth in salesBelgium Low 0.829*** 1.028*** 0.214*** 0.169 249

High 0.948*** 1.003*** 0.067** 0.111 250France Low 0.881*** 0.956*** 0.116*** 0.126 1,233

High 0.889*** 1.719*** 0.120*** 0.139 1,233Germany Low 1.396*** 0.630 0.441*** 0.005 1,119

High 1.125*** 0.724 0.295** 0.004 1,118Italy Low 0.875*** 0.378*** 0.165*** 0.096 439

High 0.843*** 0.547*** 0.137*** 0.070 440Netherlands Low 0.781*** 1.068*** 0.205*** 0.107 496

High 0.896*** 2.166*** 0.017 0.092 496Spain Low 0.944*** 0.043 0.135*** 0.025 372


High 0.906*** 1.303*** 0.065*** 0.084 577UK Low 0.967*** 0.583*** 0.086*** 0.059 5,747

High 0.932*** 1.330*** 0.101*** 0.074 5,747

Panel C: Market–book ratioBelgium Low 0.665*** 1.059*** 0.667*** 0.183 278

High 0.898*** 0.564*** 0.140*** 0.092 279France Low 0.788*** 1.368*** 0.381*** 0.094 1,507

High 0.916*** 1.007*** 0.103*** 0.135 1,504Germany Low 1.448*** 0.103 �0.452 �0.001 1,278

High 1.402*** 0.575 0.275 0.002 1,276Italy Low 0.924*** 0.485*** 0.018 0.041 475

High 0.828*** 0.327*** 0.176*** 0.060 475Netherlands Low 0.776 2.994 0.086 0.092 565

High 0.800*** 1.208*** 0.173*** 0.129 564Spain Low 0.715*** �0.212*** 0.386*** 0.047 421

High 1.028*** 0.444*** 0.057 0.059 420


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highest value relevance of accounting numbers and Germany the lowest. The

results are similar when PER is considered.

In conclusion, the differences we have obtained with our previous analysis

in: (a) the value relevance of book value and earnings across different European

countries; and (b) the cross-country difference in value relevance of accounting

information as a whole, are held after taking into consideration variables that

proxy for different economic firm characteristics.

5. CONCLUSIONS AND IMPLICATIONS

This paper focuses on the differences in value relevance of accounting numbers in

eight European countries. We explore the value relevance of two generic

accounting variables: book value and earnings. We try to answer three questions:

(a) Are there differences in value relevance between earnings and book value

across the different European accounting systems?

Table 6 (continued)

Intercept E BV Adj. R2 N

Switzerland Low 0.622*** 0.979*** 0.734*** 0.127 636High 1.003*** 0.397*** 0.077*** 0.060 637

UK Low 1.007*** 1.155*** �0.196*** 0.045 6,061High 1.004*** 0.709*** 0.075*** 0.051 6,060

Panel D: Price–earnings ratioBelgium Low 0.951*** 0.599*** 0.110*** 0.109 279

High 0.653*** 4.552*** 0.202*** 0.263 278France Low 0.952*** 1.098*** 0.094*** 0.159 1,506

High 0.858*** 1.656*** 0.091*** 0.052 1,505Germany Low 1.479*** 0.436 0.282* 0.002 1,232

High 1.108*** 1.939 0.315* 0.002 1,231Italy Low 0.839*** 0.431*** 0.200*** 0.129 475

High 0.896*** 0.001 0.076*** 0.010 475Netherlands Low 0.958*** 1.199*** 0.052* 0.092 565

High 0.709*** 3.555*** 0.095** 0.065 564Spain Low 1.069*** 0.113** 0.037 0.011 420


High 0.748*** 0.674* 0.237*** 0.125 637UK Low 1.047*** 0.839*** 0.055*** 0.069 6,059

High 0.821*** 1.869*** 0.128*** 0.036 6,060

Notes:

The estimated regressions of model (1) based on ordinary least squares. Independent variables are

earnings before extraordinary and exceptional items per share (E ) and book value (BV ). Variables in

the model are deflated by the share price at the beginning of the period. Adj. R2 is the estimated R2

adjusted to the degrees of freedom, and N is the number of observations. The standard errors are

calculated using the White (1980) heteroscedasticity-consistent variance–covariance matrix.

***significance at 0.01 level,** significance at 0.05 level, *significance at 0.10 level.


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(b) Do book value and earnings convey different information to stock

valuation?

(c) Are accounting numbers more value relevant in the countries traditionally

orientated to market investors?

Our results lead us to conclude that earnings seem to be more relevant than

book value in market-orientated countries, and vice versa in creditor-orientated

countries. These results are statistically significant in most cases. At the same

time the results show that both earnings and book value convey additional

information having incremental explanatory power to explain market prices. The

exceptions are Germany, for both figures of earnings, and Spain, in the case of net

income, which does not convey incremental information to book value.

In the same line as previous evidence, no hypothesis can be made regarding

international differences in value relevance of accounting information as a whole

(earnings and book value) based on a theoretical study of the accounting system.

According to our results, it cannot be said that accounting information from listed

companies is more value relevant in market-orientated countries than creditor-

orientated countries though earnings and book value seem to play different roles

in accounting valuation.

The general conclusion of the present study, taking into account previous

research results, is that, in the case of the European countries under study, the

existence of different accounting systems affects the relevance of the accounting

information of the companies in the stock market. This implies that the regulatory

bodies (i.e. the European Commission, the IASB and national regulatory bodies)

must reach an agreement to obtain a level of harmony that increases the

comparability, at least of the listed companies. It seems to be obvious that

there are some economic and financial differences between the countries, but

these differences are mitigated when we focus on listed companies. Some of the

national factors could be better reflected with national standards, so it is possible

that the strategy of harmonizing consolidated accounts, a strategy which has

already been suggested by the European Commission and by some of the

European countries, is the most feasible.

As a final point, we have to say that with this analysis the differences obtained

can be attributed to both, different accounting rules and different institutional

factors, which affect accounting practices. In that sense, the use of a common set

of standards (IASs) could mitigate the differences caused by the accounting rules

but not those caused by institutional and cultural factors while these differences

remain in Europe. However, these last differences seem to have significantly

decreased in the last decade, a fact our results are in line with.

ACKNOWLEDGEMENTS

We are grateful to the participants in the 23rd Annual Congress of the European

Accounting Association (Munich, 2000), to the members of the HARMONIA


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project (European Commission), and to two anonymous referees for their helpful

comments and suggestions. Financial support has been received from the Spanish

Association of Accounting and Business Administration (AECA). We also thank

the IVIE (Instituto Valenciano de Investigaciones Economicas) and the Manage-

ment School at the University of Lancaster for their support. The work is part of

the research project financed by the DGESIC (PB98-1112-C03-01),

APPENDIX A

The Vuong test compares the fit of two non-nested models. Consider two models

like:

Pit ¼ b0 þ b1BVit þ e2it ð2Þ

Pit ¼ g0 þ g1Xit þ e3it ð3Þ

Under the assumption of independence and normality of the errors of both

models Vuong develops the joint density function of the observations in the

sample and the log-likelihood function. Then, to compare the explanatory power

of the models, he uses the likelihood ratio test. The likelihood ratio statistic is

formed as follows:

LR ¼ ln LðX Þ � ln LðBV Þ ¼n

2ðlnðs2

BV Þ � lnðs2xÞÞ þ

Xni¼1

1

2

e2BV ;i

s2BV ;i

�1

2

e2X ;i

s2X ;i

!

The estimated variance of the LR is:

o2 ¼1

n

Xni¼1

1

2lnðs2

BV Þ �1

2lnðs2

X Þ

� �þ

1

2

e2BV ;i

s2BV ;i

�1

2

e2X ;i

s2X ;i

!�

1

nLR

� �2

And the Z-test statistic is:

Z ¼1ffiffiffin

pLR

o

Under the null hypothesis of no difference in explanatory power, the distribution

of Z converges in distribution to a standard normal distribution.

In practice, the estimation of the Z-statistic is completed by the following

process:

First, calculate the individual LRi:

LRi ¼ ln LðX Þi � ln LðBV Þi ¼1

2lns2BV

s2X

þ1

2

e2BV ;i

s2BV ;i

�e2X ;i

s2X ;i

!


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Then regress LRi on a constant (a vector of ones), the Z-statistic becomes

numerically equal to ððn� 1Þ=nÞ1=2 multiplied by the t-statistic on the coefficient.

APPENDIX B

Cramer (1987) shows that the density function of the R2 of the linear regression is

the following:

f ðt Þ ¼X1j¼0

oð j Þ1

Bðuþ j; v� uÞt uþj�1ð1 � t Þv�u�1

where:

oð j Þ ¼e�0:5lð0:5lÞ j

j!u ¼

1

2ðk � 1Þ v ¼

1

2ðm� 1Þ l ¼

b0X 0Xbs2

k is the number of regressors, including the intercept, m is the number of

observations and B(�) is the beta-function.

Cramer (1987) develops the statistical properties of R2, mean and variance:

EðR2Þ ¼X1j¼0

oð j Þuþ j

vþ j

EðR2Þ2¼X1j¼0

oð j Þuþ juþ j þ 1

vþ jvþ j þ 1

Like Joos (1997: 84): ‘In the empirical domain, [we] approximate both infinite

sums. The results reported in the tables are based on summations over 1500

observations terms. . . .Based on approximations of the sums, [we] compute the

empirical mean and variance of the R2 of the regression.’

The test that compares R2 from two different regressions in based on the

following Z-statistic:

Z ¼R2

1 � R22ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi

s2R2

1

þ s2R2

2

q

R21 and R2

2 are the R2 from the first and second regressions that are being

compared and s2ð�Þ its variance. Under the null hypothesis of no difference

between both R2, this Z-statistic is approximately standard normal in large samples.

One caveat of the test is that it assumes that both samples are independent. We

think that this assumption could be sustainable under our analysis.


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NOTES

1 See e.g. Nobes (1981) and reviews of this accounting research in Meek and Saudagaran(1990), Wallace and Gernon (1991), Choi and Mueller (1992) and Radebaugh and Gray(1993).

2 In particular, the results in Barth and Clinch (1996) suggest that both the treatments ofgoodwill and revaluation in the UK introduce noise in the accounting measurement ofbook value.

3 See Vuong (1989).4 Another proxy for the scale factor was applied, book value at the beginning of the

period. The results, not reported here, are in the same line as those using share price atthe beginning of the period.

REFERENCES

Ball, R. (1998) ‘Daimler-Benz AG: evolution of corporate governance from a code-law‘‘stakeholder’’ to a common-law ‘‘shareholder value’’ system’, Working paper, Univer-sity of Rochester.

Barth, M. E. and Clinch, G. (1996) ‘International accounting differences and their relationto share prices: evidence for UK, Australian and Canadian firms’, ContemporaryAccounting Research, 13(1): 135–70.

Barth, M. E. and Kallapur, S. (1996) ‘The effects of cross-sectional scale differences onregression results in empirical accounting research’, Contemporary AccountingResearch, 13(2): 527–67.

Barth, M. E., Clinch, G. and Shibano, T. (1999) ‘International accounting harmonisationand global equity markets’, Journal of Accounting and Economics, 26(3): 201–35.

Belkaoui, A. (1985) Accounting Theory. Orlando, FL: Harcourt Brace Jovanovich.Brown, S., Lo, K. and Lys, T. (1999) ‘Use of R2 in accounting research: measuring changes

in value relevance over the last four decades’, Journal of Accounting and Economics,28: 83–115.

Choi, F. D. S. and Mueller, G. G. (1992) International Accounting. Englewood Cliffs, NJ:Prentice-Hall.

Collins, D. W., Maydew, E. L. and Weiss, I. S. (1997) ‘Changes in the value-relevance ofearnings and book values over the past forty years’, Journal of Accounting andEconomics, 24(1): 39–67.

Cramer, J. S. (1987) ‘Mean and variance of R2 in small and moderate samples’, Journal ofEconometrics, 35: 253–66.

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Francis, J., Schipper, K. and Vincent, L. (2001) ‘The relative and incremental informationcontent of alternative (to earnings) performance measures’, Working paper.

Hand, J. R. and Landsman, W. R. (1999) ‘The pricing of dividends in equity valuation’,Working paper, UNC, Chapel Hill, NC.

Harris, T., Lang, M. and Mueller, H. P. (1994) ‘The value relevance of German accountingmeasures: an empirical analysis’, Journal of Accounting Research, 32(2): 187–209.

Joos, P. (1997) ‘The stock market valuation of earnings and book value across internationalaccounting systems’, Doctoral thesis, UMI.

Joos, P. and Lang, M. (1994) ‘The effects of accounting diversity: evidence from theEuropean Union’, Journal of Accounting Research, 32 (Supplement): 141–68.

King, R. D. and Langli, J. C. (1998) ‘Accounting diversity and firm valuation’,International Journal of Accounting, 33(5): 529–68.


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Meek, G. K. and Saudagaran, S. M. (1990) ‘A survey of research on financial reporting ina transnational context’, Journal of Accounting Literature, 9: 145–82.

Nobes, C. W. (1981) ‘An empirical investigation of international accounting principles: acomment’, Journal of Accounting Research, Spring: 268–80.

Ohlson, J. (1995) ‘Earnings, book values, and dividends in equity valuation’, Contem-porary Accounting Research, 11: 661–87.

Pope, P. (1993) ‘Discussion of a comparison of the value relevance of US vs on US GAAPaccounting measures using form 20-F reconciliations’, Journal of Accounting Research,31 (Supplement): 265–75.

Pope, P. and Walker, M. (1999) ‘International differences in timeliness, conservatism andclassifications of earnings’, Journal of Accounting Research, 37 (Supplement): 53–100.

Radebaugh, L. H. and Gray, S. J. (1993) International Accounting and MultinationalEnterprises. New York: John Wiley.

Smith, C. J. (1979) ‘Application of option pricing analysis’, in Ricksler, J. L. (ed.)Handbook of Financial Economics. Amsterdam, North-Holland: pp. 79–121.

Vuong, Q. H. (1989) ‘Likelihood ratio tests for model selection and non-nested hypo-thesis’, Econometrica, 57(2): 307–33.

Wallace, R. S. O. and Gernon, H. (1991) ‘Frameworks of international comparativefinancial accounting’, Journal of Accounting Literature, 10: 209–64.

White, H. (1980) ‘A heteroscedasticity-consistent covariance matrix estimator and directtest of heteroscedasticity’, Econometrica, 48: 721–46.


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