VALUE RELEVANCE OF ACCOUNTING EARNINGS AND ITS COMPONENTS

VALUE RELEVANCE OF ACCOUNTING EARNINGS AND ITS COMPONENTS

CHAPTER ONE

INTRODUCTION

1.1 GENERAL DESCRIPTION OF THE STUDY

The significance of accounting earnings for equity and firm valuation has been a topic of considerable research since the 1960s. Accounting earnings could simply be defined as the excess of income over expenditure, the earnings which is usually reflected in the financial statement of a company is usually obtained in line with the accrual concept which recognizes all income and expenses earned or incurred in a particular period irrespective of whether cash has actually been received or paid. Also, this earnings figure in the financial statement is made up of various components such as the earnings before interest and tax, earnings after tax, earnings after tax and extra-ordinary items etc.

In this context, accounting earnings would be considered as a source of information to be used by investors and analysts to enable them have an idea about the real performance of companies and also aid them in firm valuation. The value of a firm could be seen as a function of its future performance and this future performance depends on realized accounting earnings which are normally disclosed in the firm’s financial statements.

Since earnings are said to be a determinant of the value to be placed on a firm; the question would arise as to how value relevant is earnings? Earnings would be considered to be value relevant if it is able to capture and summarize the firm’s value. The value relevance would be measured as a statistical association between the financial statement earnings and the market value of the firm and earnings would be said to have quality if it is able to predict its future value.

1.2 BACKGROUND OF THE STUDY

Researches in this field of study began from the seminal work of Ball and Brown (1968) and Beaver that showed empirically the utility of accounting earnings is supposed to be relevant to appreciate the real performance of the company.

Previous studies have used different accounting variables as proxies of firms’ performance but ended up in disappointing conclusions; indeed the explanatory power of these regression models were weak, Lev (1989) attributed this result to the bad quality of accounting information.

Two studies have been developed which allows for the testing of the value relevance and the information content they are the event studies and the association studies. The event studies involves the examining of prices after the announcement of accounting information and measuring the abnormal returns which reflects a reaction of investors further to this event and the adjustment of share pries thus showing the information content.

The association studies consist of estimating regression models of market performance of the company on its financial information.

1.3 SCOPE OF STUDY

The study would cover the content analysis of the financial statements of companies in the banking and insurance sectors quoted on the Nigerian Stock Exchange between 2004 – 2008. The Nigerian Stock Exchange over the period of 2004 – 2008 has been selected because of the rapid growth which has been recorded during this short period and also the possibility of direct data collection. The findings in this paper would not be generalized to all emerging markets but, rather it can be used as a starting point for future studies and debate.

1.4 SIGNIFICANCE OF THE STUDY

It would aid investors by reducing uncertainties and information asymmetry and also boost their confidence in the use of financial statements information.

The value relevance of earnings would assist financial analysts in determining if earnings poses the desired quality to be relied upon for firm valuation.

This study would be useful for professional practitioners and future researchers as it reveals the behaviour of an emerging market in general and also serving as area research for further development or studies.

It would serve as a useful data-bank for future studies.

It would provide an insight into some of the determinants of share prices in the Nigerian Stock Market.

Earnings release is one of the measures of resolving uncertainties and enhancing the investors’ belief towards future earnings and prices in the Nigerian Stock Market.

1.4.1 CONTRIBUTIONS OF THE STUDY

Harvey (1993) and Buckberg (1993) pointed out that many emerging markets offer yields in excess of developed market returns suggesting that there might be unexploited profit opportunities to be made by investing in these markets. However, emerging markets exhibit high volatile stock prices arising form the fact that they are small markets with insufficient integration into the global economy and informational imperfections. They typically tend to be ‘noisier’ with fewer trades taking place, have limited reporting requirements and less information updates than in developed markets. Expected returns are not only affected by the uncertain economic and financial conditions of the firms but also by the political and economic environment of the country, which is less stable in developing countries.

In this context, understanding the relationship between security returns (in advance of earnings announcements) and the published earnings figures is very important to investors, financial intermediaries and regulators. If the information contribution of earnings to investors is useful, then earnings should exhibit considerable explanatory power with respect to price revisions both cross-sectional and over time.

1.5 SUMMARY OF RESEARCH METHODOLOGY

Specifically, the nature of data to be used would be from the secondary source (i.e. secondary data would be used for this study). The data would be obtained from sources such as financial statements of the selected companies, journals, government publications, relevant research works published by some researchers etc.

1.6 LIMITATIONS OF THE STUDY

This study has not been without its limitations. Firstly, we were faced with a lot of constraints and difficulties in obtaining all the needed information from the various sources.

Secondly, the re-capitalization exercise of the banking and insurance sector which led to various mergers and acquisitions made it somewhat difficult to obtain information for some of these companies which are non-existent before the exercise as such the data used in this study was based on available information.

In relation to external validity the number of samples selected from the cross-section of the population may not give the representative result of the whole population.

However, irrespective of the aforementioned limitations the benefits and conclusions reached in this study have not been dampened and allows us to measure the degree of relationship between price movement and accounting information at a particular point in time.

1.7 PROBLEM ANALYSIS

This study would be re-evaluating the information utility of accounting earnings and alternative measures such as operating earnings, cash flow from operations, earnings before taxation, gross earnings, tax etc. of some of the selected companies in Nigerian stock exchange. This would be done by testing the value relevance of these variables to explain security returns and firm valuation, while also carrying out a brief study on the information content of earnings on share prices.

1.8 RESEARCH QUESTIONS

Do earnings have a value that is relevant for the determination of a firm’s value?

Is there a relationship between security returns and accounting earnings?

Is cash flow from operations value relevant for determination of a firm’s value?

What component of earnings (before tax, after tax, gross earnings) could be said to be more value relevant?

Is there any information content in earnings which affects the snare prices of firms?

1.9 OBJECTIVES OF THE STUDY

To investigate the value relevance of accounting earnings in determination of security returns and firm valuation.

To determine if a relationship exists between the security returns and accounting earnings.

To determine if cash flow from operations is value relevant in the determination of firms’ value.

To show the effect of earnings announcement on share prices.

To show how much of earnings announcement explain abnormal security returns and the reaction of the market when earnings results are released.

1.10 STATEMENT OF HYPOTHESIS

H0: Gross earnings and accounting earnings before taxes are not as relevant as net income to explain security returns.

H1: Gross earnings and accounting earnings before taxes are more relevant than net income to explain security returns.

H0: Earnings components are not value relevant to explain security returns.

H1: Earnings components are value relevant to explain security returns.

H0: Cash flow from operating activities is not value relevant and has no incremental information content beyond net income.

H1: Cash flow from operating activities is value relevant and has an incremental information content beyond net income.

1.11 DEFINITION OF TERMS

1. Earnings: Excess of income over expenditure.

2. Efficient Market Hypothesis (EMH): Ability of share price to fully reflect all available information known or unknown about the stock.

3. Emerging Markets: Consists of most stock markets usually found in developing countries e.g. Nigerian Stock Exchange.

4. Firm Valuation: The worth or value that could be placed on a business based on its past performance useful for mergers, combinations, acquisitions etc.

5. Information Content: The ability of a share price to reflect the effect of earnings announcement.

6. Value Relevant: Ability of a financial information to measure that which it is expected to measure while predicting its future value.

7. Stock Exchange: A market where all forms of securities, stocks and shares are traded by authorized dealers or brokers on behalf of investors.