The Value Relevance of Earnings and Book Values in Brazil: Old versus New Economy
Autoria: Alexsandro Broedel Lopes
Abstract: I present evidence of the value relevance of Brazilian earnings and book values.
My results suggest that earnings and book values have low explanatory power despite the fact
that some results are statistically significant. I also show that accounting numbers are more
relevant for companies of the so-called New Economy than for companies of the Old
Economy. These results are contrary to what is normally supposed in the literature, which
assumes that New Economy companies have more intangible assets that are not measured by
traditional GAAP measures causing accounting numbers to lose relevance. The reasons
behind these results demand further investigation. One possible explanation is that Brazilian
accounting rules allow for a better representation of intangibles than US-GAAP. This is
reasonable given the current accounting system in Brazil. Another alternative explanation is
that corporate governance arrangements play a more important role than the accounting
standards in the quality of accounting information.
Key Words: value relevance; new economy companies; intangible assets; emerging markets.
Data Availability: Data are available from sources identified in the paper
I.
Introduction
The relevance of accounting information has been one of the most explored areas of financial
accounting research during the last decades. This phenomenon is partially caused by the
necessity to provide empirical evidences of the relevance of accounting information for users.
In the capital markets framework, relevance has been defined as the accounting explanatory
power in terms of the most important market variables: returns and volatility. The so-called
value relevance literature has focused on the explanatory power of accounting numbers over
prices and returns.
Results from this sort of investigation are of interest to a broad audience. Financial analysts
benefit from a deeper knowledge of which variables really affects prices and as so can be used
in their valuation activities. Regulators are interested to know which set of standards provide
information which are most useful to investors; they can compare statements prepared under
different set of standards to verify which one is more relevant in terms of market values. From
an economic perspective the relevance of accounting information is an important proxy for
the way agents reduce information asymmetry. Corporate governance arrangements use
accounting to external monitoring, managerial compensation plans, stock options etc.
In this work I investigate the value relevance of accounting variables in Brazil. This work
contributes to fill a gap in this area of research related to emerging markets. Almost all
evidence in this area is obtained from the US or Western European countries which have
relatively sophisticated markets compared to most developing countries. Evidence in
emerging markets is very limited to a few works (Lopes, 2001 and 2002). Emerging market
evidence is extremely important once it provides a laboratory to test existing theories under
extreme conditions not existent in developed countries. Despite this aspect, the role of
accounting information in developing economies remains an unanswered question.
Informational problems can reduce the relevance of accounting information as the market
becomes more inefficient. However in these markets the sources of information are limited
1
what can increase the relative relevance of accounting. This apparent puzzle demands further
investigation.
A more recent debate in the financial accounting literature regards the relevance of accounting
information for firms of the so-called New Economy. New Economy firms are normally
referred as TMT for telecommunications, media and technology. A large part of the assets in
these firms are intangible since they rely strongly on intellectual capital, research and
development etc. As traditional GAAP measures fail to recognize and measure these items
and they are especially relevant for TMT companies, it is argued that accounting will lose
relevance for valuation purposes. This argument, despite internal logic, demands empirical
verifiable evidence.
Additionally, in this work I investigate the value relevance of the Old and New Economy
companies in Brazil. My results show that earnings and book values have low explanatory
power as it is expected given Brazilian corporate governance structure and recent evidence
(Lopes, 2002). Additional evidence shows that New Economy accounting is more relevant
than Old Economy accounting contrary to what some authors suggest (Lev 1989, being the
more eloquent). The reasons behind this apparent anomaly demand further investigation.
However, some authors (Ball et all, 2001; Ball and Shivakumar,, 2001) have recently shown
that the quality of accounting is a function of the demand for financial information and not of
specific accounting standards. Corporate governance mechanisms vary from industry to
industry and this evidence can provide and promising venue for further investigation
The remaining of the paper is organised as follows: section II is designed to put this work in
the context of prior research; section III provides a description of the Brazilian corporate
financial reporting system; section IV describes the models used, presents the data and the
results and section V concludes the paper.
II.
Relation to Prior Research
I contribute to a growing literature on international accounting which includes Jacobson and
Aaker (1993), Alford et all (1993), Amir et all (1993), Bandyopadhyay et all (1994), Harris et
all (1994), Joos and Lang (1994), Barth and Clinch (1996), Pope and Walker (1999), Ball et
all (2001) and Chan and Seow (1996). This literature is also related to the role of accounting
information in corporate governance arrangements (Bushman and Smith, 2001). Without
institutional arrangements accounting information would be relevant only as a source of
information about risk and expected return for securities. With the agent-principal conflict
corporate governance schemes are necessary. Accounting information plays a fundamental
role in these contracts. This work addresses how accounting information is related to market
variables such as prices and returns. Brazilian corporate governance structure provides an
interesting opportunity to test as it is showed in next section.
III.
An Overview Of The Brazilian Accounting System And Capital Markets
Brazilian Corporate Financial Reporting System
Modern Brazilian Corporate Financial Reporting System can traced back to 1976 with the
issuance of the Company Law (Lei das Sociedades por Ações). At that time the military
government issued a relatively sophisticated company’s law to trying to foster the
development of a emerging capital market. In the same year the government created the
Brazilian Securities and Exchange Comission (CVM) to regulate capital markets in Brazil.
2
This function was previously with the Central Bank of Brazil. With the new structure the Law
established the major accounting guidelines and the CVM was in charge of specific guidance
on more technical aspects. In addition to compliance with the Law and CVM specific
requirements Brazilian companies have to hire external auditors to verify the compliance of
their accounts to Brazilian GAAP. Financial institutions continued to be regulated by the
Central Bank which issued a Plan of Accounts (COSIF) to orient their accounting policies.
Those financial institutions are held in a dual regulatory scheme that frequently results in
conflicts. In addition, the Brazilian Institute of Accountants (IBRACON) also issues
statements that are generally considered to be GAAP. The major aspects approached by the
Brazilian Company Law are summarized in Lopes (2002).
Despite this rigid structure sometimes the Law is simply not considered. Recently, in two
opportunities, the CVM issued statements allowing deferment of exchange related expenses
over a period of several years. The previous regulation clearly expressed that such items
should be accounted for in the same period of the devaluation and not deferred for years to
come. The justification of this action was that the devaluation of the Brazilian currency the
Real would cause unrealistic losses for companies.
The Real Plan, which was implemented in 1994, was an (successful) attempt to control
inflation in Brazil. Inflation levels dropped from more than one thousand percent in 1993 to
very lower levels in 1994 and 1995. After 1995 the Ministry of Finance stop allowing the use
of the Brazilian Method for Inflation Adjustment (BMIA) which. Clearly the profession was
not consulted regarding this aspect.
Another important feature of Brazilian accounting is the influence of tax legislation. In almost
all important matters, as can be seen from the above description, tax rules have direct
influence in the numbers reported. Representants of the profession in Brazil clearly recognize
this reality. Da Costa (1993:13) commenting on the financial statements produced in Brazil:
“are used with little effectiveness by corporations that usually comly merely with their legal
obligations”.
Given this structure the Brazilian Corporate Financial Reporting System can be analysed
under the findings of Ali and Hwang (2000). First, Brazil has a bank-oriented system where
domestic capital markets have an insignificant role in providing funds for companies. The
recent flow of Brazilian companies to US markets through American Depositary Receipts is
just a sign of that phenomenon. Second, private sector bodies are irrelevant in setting
accounting rules in Brazil. Ultimate power remains in the government and the major
accounting orientation is still a Corporate Law, which requires Congressional approval. Third,
Brazil has clearly a Continental model accounting system despite the strong US influence in
business in Latin America. Fourth, tax rules are dominant in Brazil. Companies typically
present their financial statements according to tax regulations despite the arbitrary motivations
of some of those regulations. The fifth aspect cannot be determined in this study since I do not
have reliable evidence on how much money is spent on external auditing. Additionally, some
aspects of capital markets in Brazil add to this inimical scenario. The section below discusses
these last features.
Brazilian Capital Markets
This work does not intend to provide an exhaustive coverage of Brazilian financial markets.
Only aspects considered to be relevant to the determination of the relevance of accounting
3
information were considered. The general conditions of functioning and corporate governance
in Brazil have a direct impact on the demand for accounting information. The most important
aspects are described below:
Shareholder’s Control and Institutional Factors: Ownership concentration is relatively
high in Brazil as Lopes (2002) shows. This concentration reduces dramatically the demand for
accounting information because large shareholder have special access to information and in
Brazil they normally are, or are closely related to, managers.
Sources of Funds: the sources of funds to firms are fundamental to the understanding of the
role of accounting. Despite the fact that both providers of debt and equity use accounting
information they differ significantly. In Brazil the scenario is dominated by credit policies as
Studard (2000: 15) comments “since the 1950’s, the financing of economic development in
Brazil has relied significantly of selective credit policies, inflationary financing and external
saving. We claim that in the 1990’s and for the first time in its post-war history, due to the
developments both in the international and in the domestic financial markets, there existed
opportunities to develop non-inflationary private sources of long term finance and to reduce
its dependency on foreign savings. These opportunities have been so far spared due to the lack
of policies towards enhancing the some of the positive aspects of recent developments in
Brazil’s financial systems, and avoiding excessive volatility and instability of financial
markets”.
State Participation in the Economy: the atrophy of the private sector in providing funds for
firms in Brazil is also a function of the participation of the Brazilian government in the
economy, which is quite high. According to Anderson (1999:54) “…the government
frequently responds to high inflation, volatile growth and capital flight with sweeping
heterodox policies characterized by reliance on wage and price controls. These economic
plans (Cruzado Plan, 1986; Bresser Plan, 1987; Summer Plan 1989; Collor I, 1990; Collor II,
1991; Real Plan, 1994) substantially revise the fundamental rules of the game for transactions
among private parties. In particular, these plans often unilaterally amend contract terms,
particularly inflation indexation. These plans affect a financial contract directly when its terms
are altered by government fiat and indirectly when other contracts are manipulated.
This overview of the Brazilian accounting system and capital markets clearly indicates that
accounting information is expected to be of low quality due to both the conditions in the
profession and the capital markets structure.
IV.
Models, Hypothesis, Data And Empirical Results
Recent empirical evidence has showed that accounting information can be of very low
relevance in Brazil given its corporate governance structure (Lopes, 2001). I use the model
proposed by Harris et all (1994):
(Pjt + djt – Pjt-1)/Pjt-1 = 0t + 1t( Lucjt –Lucjt-1)/Pjt-1 + 2t Lucjt/Pjt-1 + jt
(1)
Where:
Pjt = stock price of the company j at the end of year t (1999);
Pjt-1 = stock price of the company j at the end of year t-1 (1998);
djt = dividends paid per share on year t (1999);
Lucjt = accounting earnings per share for company j for year t (1999);
4
Lucjt-1 = accounting erarnings per share for company j for year t (1998);
jt = regression error term
This regression is designed to evaluate the explanatory power of earnings and earnings
changes. The sample was selected from the Economatica database for the years of 1999 and
1998. Additionally, the sample was segregated into two subgroups: Old Economy and New
Economy (hereafter Old and New groups). The Old group is composed of companies from
steel plants, textile, metallurgy, industrial mechanics, chemical, ore processing and
petrochemical. The New group was composed of companies of the telecommunications sector
because of sample limitations. The New group is composed of 73 companies and the Old
group is composed of 91 companies. The period (1998-99) was selected due to the absence of
statistically reliable data before
TABLE 1 Descriptive Statistics
NEW
Mean
Standard Deviation
Median
Max
Min
Price 1998
10,94
19,99
0,029835
118,0101
0,0001
Price 1999
17,70
28,34
0,069682
113,552
0,00004
Earnings 1998
0,168
0,9663
0,000861
5,885395
-0,0122
Earnings 1999
0.153873
0,925748
0,0000279
5,631093
-0,06667
Dividends 99
0,1763
1,0464
0,0000607
6,368
0
OLD
Mean
Standard Deviation
Median
Max
Min
Price 1998
1,7156
5,5469
0,0235
40,2593
0,0000193
Price 1999
3,9578
11,7645
0,0578
67,16
0,00008
Earnings 1998
-4,24083
30.7589
0,000725
12,575
-245,373
Earnings 1999
-0,13915
3,3634
0,0014
12,4275
-24,1607
Dividends 99
0,18579
0,92114
0,000326
8.2
0
The statisitcs show the great dispersion in the data as expected for a country like
Brazil. Table 2 shows the results of regression (1) with p-values in parenthesis.
TABLE 2 Results for (Pjt + djt – Pjt-1)/Pjt-1 = 0t + 1t( Lucjt –Lucjt-1)/Pjt-1 + 2t Lucjt/Pjt-1+jt
Groups
N0 Companies
0t
1t
2t
R2
Durbin-Watson
New
73
1,52
-0,39
1,61
0,147
No Autocorrelation
(0,0000)
(0,0019)
(0,021)
2,17
-0,069
0,08
0,055
No Autocorrelation
(0,0000)
(0,0275)
(0,0612)
1,86
-0,065
0,03
0,034
No Autocorrelation
(0,0000)
(0,0192)
(0,0486)
Old
Total
91
164
The results show that accounting earnings are statistically significant suggesting that
earnings are relevant to explain returns in Brazil for Old and New companies. However, the
explanatory power of the regressions is low what indicates that earnings explains only a small
5
parcel of returns behaviour. The most interesting aspect, however, is that New Economy
earnings seem to explain returns better than Old Economy earnings. As so, the argument
raised by Lev (1989) does not seem to fit well with Brazilian evidence.
To complement this evidence the model presented below is used to test the value
relevance of book values instead of earnings to explain returns.
(Pjt + djt – Pjt-1)/Pjt-1 = 0t + 1t( BVjt –BVjt-1)/Pjt-1 + 2t BVjt/Pjt-1 + jt
(2)
Where:
BVjt = Book value of equity per share for company j for year t (1999);
BVjt-1 = Book value of equity per share for company j for year t-1 (1998);
With this new specification it is possible to evaluate the role of book values (BV
hereafter) and changes in book values to explain earnings in an alternative model. Table 3
presents the descriptive statistics for this new set of variables
TABLE 3 Descriptive Statistics for Book Values
New
Mean
Standard Deviation
Median
Max
Min
BV 98
0,975603
5,276152
0,030952
32.18001
0,000124
BV 99
1,064829
5,843077
0,030742
35.62894
0,000158
Old
Média
Standard Deviation
Media
Max
Min
BV 98
-0,058
29,09
0,06193
145,9656
-162.1065
BV 99
2,94
17,64
0,064092
151,67875
-45.82107
As expected, the dispersion in the sample is very high compared with numbers
obtained in more developed markets. The results of equation (2) are presented in Table 4.
TABLE 4 Results for (Pjt + djt – Pjt-1)/Pjt-1 = 0t + 1t( BVjt –BVjt-1)/Pjt-1 + 2t BVjt/Pjt-1 + jt
Groups
N0 Companies
0t
1t
2t
R2
Durbin-Watson
New
73
0,85
0,61
0,39
0,41
No Autocorrelation
(0,0000)
(0,0057)
(0,0000)
1,84
-0,0012
0,045
0,05
No Autocorrelation
(0,0000)
(0,94)
(0,047)
1,56
0,0082
0,07
0,081
No Autocorrelation
(0,0000)
(0,60)
(0,0003)
Old
Total
91
164
These results show that book values explain relatively well returns for the New group
in opposed to Old group. For the aggregate sample the explanatory power continues to be low
but higher than the earnings specification. The specification following (3) is a natural
6
consequence of the two specifications presented initially. The basic idea is to evaluate the role
of earnings and book values (levels and changes) together.
(Pjt + djt – Pjt-1)/Pjt-1 = 0t + 1t( BVjt –BVjt-1)/Pjt-1 +2t( Lucjt –Lucjt-1)/Pjt-1 +
+3t BVjt/Pjt-1 + 4t Lucjt/Pjt-1 + jt
(3)
The results from the specification above is shown on Table 5 below.
TABLE 5 Results for (Pjt + djt – Pjt-1)/Pjt-1 = 0t + 1t( BVjt –BVjt-1)/Pjt-1 +2t( Lucjt –Lucjt-1)/Pjt-1 +3t BVjt/Pjt-1
+ 4t Lucjt/Pjt-1 + jt
Grupos
0t
11
2t
3t
4t
R2
D-W
New
0,89
0,60
-0,33
0,38
0,50
0,50
No Autocorrelation
(0,0000)
(0,0184)
(0,0009)
(0,0000)
(0,45)
1,9289
-0,072
-0,060
0,054
0,1616
0,13
No Autocorrelation
(0,0000)
(0,1012)
(0,051)
(0,021)
(0,0075)
1,60
-0,064
-0,058
0,080
0,1612
0,14
No Autocorrelation
(0,0000)
(0,10)
(0,0279)
(0,0091)
(0,0024)
Old
Total
The specification (3) has a higher explanatory power than specifications (1) and (2).
The results are significant for almost all variables and the explanatory power for the New
group high, specially when compared with studies performed internationally (Harris et all,
1994). These results show that accounting numbers combined provide a reasonable picture of
returns behaviour for New Economy companies. The results are less impressive for Old
Economy but the coefficients are all statistically significant at least at the 10% level.
The superiority of the New Economy numbers is apparently a puzzle given the
argumentation discussed before (Lev, 1989). One possible solution is that Brazilian GAAP
(BR-GAAP) represents better intangibles than US-GAAP. According to BR-GAAP, research
and developments can capitalised and amortised over a relative long period of time (10 years).
This possibility can represent better the real economic picture of the firm in opposition to US
companies that are not allowed to capitalise those expenses. According to Barth et all (2001),
accruals are good predictors of future cash flows and so of firm’s value. This can be a light on
the role of research and development capitalization in BR-GAAP. According to this
interpretation LEV’s (1989) ideas can be reconciliated with my results. Another possible
interpretation is that there are other factors that can influence the relevance of accounting
information in this particular industry which were not investigated. This is classical case of
omitted variables. Recent research on corporate governance shows that the relevance of
accounting information cannot be fully understood without a clear consideration of corporate
governance mechanisms. This is especially true for the inimical circumstances which
Brazilian firms face in order to finance their activities (Anderson, 1999).
V.
Conclusions and Implications for Future Research
7
This work investigated the role of accounting information to explain returns in Brazil. My
results show that earnings do not have a high explanatory power. Book values have higher
explanatory power than earnings reflecting the corporate governance model of Brazil. The
high concentration in ownership reduces the demand for earnings as reducers of information
asymmetry. Large shareholders do not depend on earnings to obtain information about
company’s performance once they have privileged access to information. Additionally, I
provide evidence of the value relevance of the so-called New Economy companies
(telecommunications) compared to Old Economy Companies (steel plants, textile, metallurgy,
industrial mechanics, chemical, ore processing and petrochemical). The results, contrary to
what is stated in the literature, show that New Economy accounting has more explanatory
power than Old Economy accounting. This result can be related to accounting rules in Brazil
that allow for capitalization of intangibles. Alternatively, these results can be due to corporate
governance arrangements for these companies as also suggested in previous studies. Future
work can address the reasons behind these results in order to increase our understanding of the
determinants of accounting relevance.
VI.
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