We investigate the changes in the value relevance of accounting information among Chinese firms over the past two decades, during which accounting reforms are launched to provide decision makers with increased disclosure and higher quality financial information. We also investigate the factors that differentiate firms showing significant value relevance improvement from firms showing little improvement. We find increases in the value relevance of some financial variables and decreases in others, which suggests that accounting numbers help to explain the pricing process of stock shares although at different levels. In addition, we find that value relevance improvements are more pronounced for smaller firms, firms with lower growth rates, and those with greater asset tangibility. We also document that value relevance improvements are generally lower in an exuberant stock market. These results have implications for a variety of information users and policy makers in emerging countries which are reforming their accounting systems.
This paper investigates the changes in the value relevance of accounting information among Chinese firms over the past two decades. Value relevance is defined as the informativeness of financial statements. The higher the value relevance, the more financial statements can be relied upon to make investment decisions and thus the greater the association between financial statement items and firm stock-share prices or returns (Francis and Schipper, 1999 and Sami and Zhou, 2004). The purpose of this paper is to provide greater insight into changes in value relevance and the factors that influence value relevance against a background of accounting reforms in a broad sense, rather than charting the causal relationship between accounting reforms and the value relevance of accounting information.1
Our study is primarily motivated by the unique environment of the Chinese emerging market, in which accounting standards, regulations, and practices have experienced revolutionary change over the past two decades.2 Another motivation comes from the mixed results documented in the literature on the value relevance of accounting information based on U.S. data. For instance, whereas some studies find increases in the value relevance of accounting information over time (Collins et al., 1997 and Landsman and Maydew, 2002), others show that value relevance has in fact been decreasing over time (Lev, 1989 and Brown et al., 1999) or changes are in different directions when different accounting items are used (Francis and Schipper, 1999). To shed light on this issue, we use the emerging market of China as an experimental setting, where the majority of publicly listed firms are traditional manufacturing and merchandising firms and where the role of new-economy firms is more limited than in developed markets.
We address the topic by studying two research questions. The first is whether, with the accounting and regulatory reforms that have occurred in China in the past two decades, the value relevance of financial information has increased for investors. Our principal measure of value relevance is the change in the ability of the key accounting variables, such as assets, liabilities, and earnings, to explain stock returns and market value. Given the accounting and regulatory reforms of the past two decades, we expect the power of the key accounting variables to explain stock returns and market value to improve over time. The second issue that we investigate is whether factors such as firm size, growth, monitoring by long-term debt holders, cross-listing, state-ownership, and auditor characteristics affect changes in the value relevance of financial information. We use changes in the absolute value of the residuals from four evaluation models to measure improvements in the value relevance of accounting information.
Consistent with the literature, we find that earnings level and earnings changes are positively associated with the pricing process in most years. Interestingly, the balance sheet relation does not behave as predicted until after 2002, when total assets are positively and liabilities negatively associated with firm value. Further analysis using the lagged book value of equity as an alternative deflator rather than outstanding shares indicates that the unexpected signs in the earlier years may be the result of dramatic changes in outstanding shares.
To test the changes in value relevance at different stages of the accounting and regulatory reforms, we group the regressions into three periods. In all cases, the regressions for the later period are closer to the true models than those for the earlier periods. Overall, the results suggest that the accounting numbers do help to explain the pricing process of stock shares in the emerging market of China, which is consistent with earlier studies (e.g., Sami and Zhou, 2004).
We do not find evidence that the value relevance of the models changes uniformly in the same fashion over time. On the contrary, we find that the value relevance of the balance sheet relation increases whereas that of the book value and earnings relation decreases over the period studied. Moreover, we do not find a significant change in the pattern of the value relevance of the earnings relation and the accruals and cash flow relation. This result is consistent with the notion that the usefulness of specific accounting information varies with its necessity at different stages of economic development. Finally, using the change in the absolute value of the residual as a measure of improvements in value relevance, we find that smaller firms, firms with lower growth rates, and those with greater asset tangibility experience more pronounced value relevance improvements. Moreover, the value relevance of accounting information is generally lower when the stock market is more optimistic.
The remainder of this paper is organized as follows. Section 2 discusses the background of financial disclosure practice and the institutional setting. A literature review and research questions are presented in Section 3. Section 4 discusses the sample, variables, and empirical method. Section 5 discusses the results and the empirical analyses. Finally, Section 6 presents our conclusions.
We investigate changes in the value relevance of accounting information among Chinese firms over the past two decades. Specifically, we propose that the usefulness of accounting information in making decisions differs at different stages of economic development that is accompanied by accounting, auditing, and institutional reforms. We further investigate the factors that differentiate firms showing significant value relevance improvement from firms showing little improvement.
As expected, we find that earnings level and earnings change are significantly and positively associated with the pricing process in most years. Total assets are positively and liabilities are negatively associated with firm value only after 2002. Book value and earnings are positively associated with firm value, whereas the earnings to lagged book value ratio has less stable coefficients. Finally, accruals and cash flow information remain positively associated with firm value in all of the sample years except for the starting year of 1998.
However, we do not find uniform patterns in the changes in value relevance as measured by the R-squares for these relations. For the balance sheet model, the R-squares generally increase over the years, which is consistent with the notion of the increasing value relevance of balance sheet data. For the book value and earnings relation, the R-squares decrease over the years. We find no clear pattern of changes in value relevance for the other two relations.
We also investigate the average absolute value of the residuals from Models (1) to (4) as an inverse measure of value relevance, as this value represents the unexplained portion of stock returns and prices. Interestingly, 2000 and 2007 show higher residuals than the other years, and these years are associated with the highest stock returns. This correlation suggests that the value relevance of accounting information is generally lower when the stock market is more optimistic. In all other years, the residual values are relatively modest.
Finally, we provide evidence that value relevance improvements are more pronounced for smaller firms, firms with lower growth rates, and those with greater asset tangibility. Our results thus suggest that the gap in accounting quality between larger and smaller firms is narrowing. Our results also corroborate the previous finding (e.g., Lev, 1989 and Lev and Zarowin, 1999) that traditional accounting models fail to adequately measure firms that rely mostly on intangible assets and growth potential. This is true even in the emerging market of China.
As with similar studies on changes in the value relevance of accounting information (e.g., Francis and Schipper, 1999 and Lev and Zarowin, 1999), our study has certain limitations. The purpose of the study is not to document a casual relationship between accounting reforms and the value relevance of accounting information. Rather, the primary purpose is to provide greater insight into the changes in value relevance and the factors that influence it.17 We are unable to provide direct evidence on the impact of a particular accounting reform on the value relevance of accounting information because the accounting reforms in China have been accompanied by many related auditing, regulatory, and human capital reforms. Hence, in referring to accounting reforms in this study, we also include (1) improvements in auditing standards (e.g., Zhou, 2007), and improved independence due to the auditor disaffiliation program of 1997–1998 (Gul et al., 2009); (2) improvements in human capital, especially those relating to the increase in the accounting talent pool, which mitigates the shortage of qualified personnel in the early stages of the reform; and (3) reforms in the judiciary system, particularly the CPA Act of 1994 and the Securities Act of 1998. We do not believe that we can separate each of these reforms and we make no attempt to do so.
The findings of our study have interesting implications for a variety of information users. First, our study provides useful information on the value relevance of accounting information in emerging markets. Second, policy makers could use the information to evaluate the effectiveness of their policies and determine future reform directions to improve those policies. Future studies could further explore the market consequences of improving the quality of financial information, such as the effects of increased disclosure on other key capital market characteristics, including stock price synchronicity, information asymmetry, and the cost of equity capital.
