Hung-Shu Fan
Ching-Lung Chen
The Effect of SFAS No.34 on the Value-Relevance of
Earnings and Equity Book Value
(Received Dec 2, 2008; First Revision Jul 7, 2009; Second Revision Jun 8, 2010;
Accepted Jan 23, 2011)
Introduction
The Statement of Financial Accounting Standards No.34
in Taiwan (hereafter, SFAS No. 34) requires entities to
recognize financial instruments as assets or liabilities at
their fair values on the balance sheet and to include the
resulting gains or losses from the fair value change of
financial instruments as a component of earnings. The
standard provides more specific guidance compared to
the previous accounting standards in determining the
fair value of financial instruments. This study
conjectures that SFAS No.34 would have effects on
both income statement and balance sheet and provides
us with a unique opportunity to identify a distinct
sample in examining the impact of SFAS No.34 on the
value-relevance of accounting numbers. Thus, the
purpose of this paper is to examine the possible
regulating effects on the value relevance of earnings and
equity book values of listed firms in Taiwan which
recognized financial instruments regulated under SFAS
No. 34.
The impact of SFAS No.34 on income statement
triggered from recognizing the gains/losses of fair value
changes on financial instruments should be considered
as a noise impounded in the current earnings. As noted
by Feltham and Pae (2000), “noisy” net income that
garbles rather than improves the information value of
the accounting numbers results in lower earnings’
quality/value-relevance. We infer that earnings variable
is less value-relevant in determining stock price after
the enforcement SFAS No.34. In contrast, because of
recognizing fair value of financial assets and/or
liabilities into balance sheet, SFAS No.34 should result
in a more correct equity book value and enhance the
value-relevance of equity book value. Moreover,
Burgstahler and Dichev (1997) document an
option-style valuation model based on the prediction
that equity value is a convex function of both earnings
and book value. We conjecture that equity book value
will play a relatively more important role in explaining
Hung-Shu Fan is Professor of Department of Accounting,
Fu Jen Catholic University.
E-mail: 038773@mail.fju.edu.tw
Ching-Lung Chen is Professor of Department of
Accounting, National Yunlin University of Science &
Technology. E-mail: clchen@yuntech.edu.tw
The authors gratefully acknowledge the two anonymous
reviewers for their constructive comments and the financial
support of Fu Jen Catholic University (No. 409731074079)
stock prices because of poor quality earnings and
investors must rely more heavily on equity book value
in setting stock prices following SFAS No.34
enforcement.
This study enriches the financial instrument-related
research from three angles. First, we provide some
first-hand evidence on the potential economic
consequences of SFAS No.34. In terms of the value
relevance on financial statement components, this study
also provides insights into the quality of the financial
information provided to the market after a new standard
is implemented. Second, Barth, Beaver and Landsman
(2001) argue that the tests of value relevance represent
one approach to operationalize the FASB’s stated
criteria of relevance and reliability. Beresford and
Johnson (1995) also suggest that ex post research is
valuable and provides the FASB in assessing the
effectiveness of standards that have been issued. Thus,
this study responds to the suggestions of Barth, Beaver
and Landsman (2001) and Beresford and Johnson (1995)
and provides empirical findings for regulators in
evaluating the possible effect of SFAS No. 34. Finally,
recent studies have aimed at specifying the conditions
under which earnings or equity book value would either
be assigned a relatively higher weight in explaining
stock values (e.g., Collins, Maydew and Weiss 1997;
Francis and Schipper 1999; Barth, Beaver and
Landsman 1998). This study extends this stream of
research and examines the possible value-relevance
tradeoff effect of earnings and equity book value under
a new standard (i.e., SFAS No.34) enforcement in
Taiwan.
Related Research and
Hypothesis
A couple of studies have aimed at specifying the
conditions under which earnings or equity book value
explain a relatively higher proportion of the market
value of the equity (e.g., Burgstahler and Dichev 1997;
Collins, Maydew and Weiss 1997; Lev and Zarowin
1999; Black and White 2003; Francis and Schipper
1999; Barth, Beaver and Landsman 1998; Ou and Sepe
2002). Only moderate studies investigate the
incremental information content or value-relevance of
financial instruments disclosures beyond earnings and
equity book value under accounting standards
regulations. Barth, Beaver and Landsman (1996) and
Eccher, Ramesh and Thiagarajan (1996) employ a
Management Review
Vol. 32 (July 2013), 117-122
cross-sectional valuation framework and find that fair
value disclosures provide incremental explanatory
power beyond book value under SFAS No.107.
Venkatachalam (1996) investigates the value-relevance
of banks’ financial instruments disclosures provided
under SFAS No.119 and evidences that the fair value
estimates for financial instruments help explain
cross-sectional variation in banks’ share prices. The
author documents that the fair values have incremental
explanatory power over and above the notional amounts
of financial instruments. Fan and Chen (2009) examine
the effects of asset impairment standard (SFAS No.35 in
Taiwan) on the value-relevance of accounting numbers.
They explore the prediction, based on the inference that
early SFAS No.35 adoption makes both equity book
value approach its economic value and earnings more
noisy than before, that the value-relevance of equity
book value (earnings) increases (decreases) as firms
voluntarily adopt this new standard early. Extending this
stream of studies, we examine the relative
value-relevance changes of earnings and equity book
value under the enforcement of SFAS No.34.
Based on the valuation framework that an
enterprise's intrinsic value is equal to its current book
value plus the present value of residual earnings, Lev
and Zarowin (1999) suggest that accounting standards
which improve the alignment of reported book value
with the firm's intrinsic value and/or improve the
prediction of earnings should be preferred over
standards which do not. We know that earnings and
equity book value are two key financial summary
measures used in capital market participants’ investing
decisions. The fair value based recognition and
measurement of financial instruments required by SFAS
No.34 provides an even more interesting context for
examining investors’ perceptions of the value-relevance
changes in accounting numbers regulated by this
standard. This study refers that the income statement
impact of SFAS No.34, resulted by the fair value
changes of the held-for-trading financial assets and
held-for-trading financial liabilities, would be taken as a
noise impounded in the current earnings and, thus,
impair earnings persistence and decrease the value
relevance of earnings. Alternatively, the same treatment
of this new standard, which is applied for financial
instruments, should make equity book value approach
its intrinsic value, in turn, enhance the informativeness
of equity book value. The combination of these two
co-existed effects resulted from SFAS No.34 regulation
will make investors rely more (less) heavily on equity
book value (earnings) in setting stock prices. Based on
such inference, this study predicts that the enforcement
of SFAS No.34 makes the value-relevance of equity
book value (earnings) increases (decreases). This study
therefore establishes the hypothesis as follows:
H1: The enforcement of SFAS No.34 makes the
value-relevance of equity book value (earnings)
increases (decreases).
118 Management Review, July 2013
Data and Model
Years 2005~2006 are chosen as the observation years
because SFAS No.34 is enforced for 2006 annual
reports.
TSE-listed and OTC-listed firms are
considered dues to the feasibility of collecting the
necessary reliable data. We delete firms whose
accounting period ends were not December 31 for
consistency and delete banking and insurance industries
for their regulated peculiarities. This study yields the
final sample of 2,333 (1,148 and 1,185 for year 2005
and 2006, respectively) firm-year observations to
examine the hypothesis. The empirical data are
retrieved from the Taiwan Economic Journal Database.
We follow prior research (e.g., Barth, Beaver and
Landsman 1998; Ou and Sepe 2002; Black and White
2003; Nwaeze 1998; Arce and Mora 2002; Fan and
Chen 2009) and express stock price (P) as a function of
earnings (EPS) and equity book value (BV). We know
the listed firms in Taiwan must input annual reports into
the Open Market Observation Post System before April
30 of the next year under the regulation of Taiwan
Securities Exchange Law §36. Following Chin, Lin and
Chi (2004), this study uses stock price per share on
April 30 of the next year as dependent variable.
Particularly, to capture the complete effect of SFAS
No.34 on the value relevance of accounting numbers,
we incorporate the dummy variable for the enforcement
of SFAS No.34 (D_34) into the empirical model (Fan
and Chen 2009). A revision of Ohlson (1995) model that
includes the two interactive variables between the
dummy variable for the enforcement of SFAS No.34
and earnings/equity book value, respectively, is
estimated. Naturally, this model also includes 22
industrial dummy variables to control the possible
industry effects on stock price (Aboody, Barth and
Kasznik 2004).
Furthermore, this study uses the natural logarithm
of total assets as a proxy for firm size (SIZE) to control
the potential risk effect of firm size on the value
relevance of accounting numbers (Fama and French
1992). Firms with higher debt level are more likely to
be subjected to covenants from bondholders that could
hinder them from undertaking new long-term
investments, in turn, affect firms’ value. This study
incorporates leverage variable (LEV) into empirical
model to control the influence of debt contracts (Barth,
Beaver and Landsman 1998). When its earnings to
equity book value ratio is high, the firm is likely to
continue its current way of using resources and earnings
is the more important determinant of equity value
(Burgstahler and Dichev 1997). This study incorporates
the return on equity variable (ROE) into empirical
model to control this effect on stock price. Negative
earnings suggest these firms encounter financial
problems (Barth, Beaver and Landsman 1998). Thus, it
is worth a try to incorporate a dummy variable for the
negative earnings firms (LOSS, denoted as 1 if the firm
has negative earnings, otherwise 0) into the model to
enhance the model specification (Jan and Ou 1995;
Collins, Pincus and Xie 1999). The empirical model is
presented as follows:
Pjt   0  1 EPS jt   2 BV jt   3 D _ 34 jt * EPS jt   4 D _ 34 jt * BV jt
22
  5 LEV jt   6 SIZE jt   7 ROE jt   8 LOSS jt    9i D _ IND ijt  jt
i 1
(1)
According to our hypothesis, the coefficient of β3
represents the incremental value relevance of EPS for
the enforcement of SFAS No.34 and will be negative.
Concurrently, the coefficient of β4 represents the
incremental value relevance of BV for the enforcement
of SFAS No.34 and will be positive.
Empirical Findings
From Table 1, the coefficients on EPS and BV are both
positive and statistically significant at the 1% level.
These findings are consistent with those of previous
studies that there is a strong positive relationship
between share price and earnings/equity book value.
Most importantly, the coefficients on the first pivotal
explanatory variable D_34*EPS are -4.96(t=-2.10) and
-5.00(t=-2.13), all negative and statistically significant
at the 5% level in the with/without industrial-dummy
models, respectively. This result suggests that the
enforcement of SFAS No.34 has a negative impact on
the value relevance of earnings. Conversely, the
coefficients on the second pivotal explanatory variable
D_34*BV are 0.56(t=2.69) and 0.57(t=2.71), all
positive and statistically significant at the 1% level,
respectively. It suggests that the enforcement of SFAS
No.34 has taken as noisy information impounded in
current earnings and makes investors rely more heavily
on equity book value in setting stock prices. As
predicted, there is indeed a negative impact of SFAS
No.34 on the value-relevance of earnings to reflect that
the recognized gains/losses triggered by the fair value
change of financial instruments which, in turn,
decreases the value-relevance of earnings and increases
the value-relevance of equity book value.
Conclusion
This study explores the hypothesis that the value
relevance of earnings (equity book value) decreases
(increases) for the enforcement of SFAS No.34. The
empirical results, as conjectured, provide confirmatory
evidence to support this hypothesis. According to the
empirical findings, the value relevance decrease of
earnings is tradeoff by the value relevance increase of
equity book value, the value relevance on financial
statement components had indeed changed after this
new standard is implemented. Because the analysis is
based on the stylized Ohlson model, the usual caution
with joint model fitting and SFAS No.34 effect should
be employed in interpreting the results. In addition, this
study adopts a broad approach to examine the
consequences (i.e., value-relevance) of SFAS No.34,
instead of the motivations to adopt this new standard.
Thus, we cannot remove the possibility that such
motivations constitute bias in the empirical findings.
In order to gain confirmatory evidence, we
implement some diagnostic checks and demonstrate that
the empirical results are robust to these various
specifications. These additional examinations include
deleting sample firms with negative equity book value
test, deflating the related variables by total assets test,
excluding the non-financial instruments users test,
controlling the effect of SFAS No.35 test, and
incorporating interactive control variables test. These
additional results are summarized into Table 2 and
provide confirmatory evidence to support the initial
findings.
Effect of SFAS 34 on Value-Relevance
119
Table 1 Results from Regressions of Stock Price on Earnings, Book Value
and Two Interactive Variables for the Enforcement of SFAS No.34
Dependent Variable (P)
Pooled regression with
industrial-dummy
22.50**
(t=2.08)
Pooled regression without
industrial-dummy
34.88***
(t=4.34)
EPS
13.76***
(t=5.81)
13.76***
(t=5.81)
BV
1.79***
(t=4.07)
1.83***
(t=4.35)
D_34*EPS
-4.96**
(t=-2.10)
-5.00**
(t=-2.13)
D_34*BV
0.56***
(t=2.69)
0.57***
(t=2.71)
LEV
21.12***
(t=3.62)
18.98***
(t=3.75)
SIZE
-4.32***
(t=-4.54)
-4.33***
(t=-5.75)
ROE
-1.03***
(t=-2.98)
-0.98***
(t=-2.79)
LOSS
34.18***
(t=6.17)
35.34***
(t=6.36)
D_IND
Ignored
---
2,333
2,333
0.59
0.58
Explanatory Variables
Intercept
N
Adj-R
2
***
111.53
397.69***
F-value
1. Legends:
P: stock price per share on April 30 of next year.
EPS: reported earnings per share during the calendar year.
BV: book value per share at the end of the calendar year.
D_34: dummy variable for the enforcement of SFAS No.34. We denoted year 2006 as 1, otherwise 0.
LEV: debts to assets ratio at the end of the calendar year.
SIZE: the natural logarithm of total assets at the end of the calendar year.
ROE: return on equity at the end of calendar year.
LOSS: dummy variable for the firms with negative earnings. The firm with negative current earnings is
denoted as 1, otherwise 0.
D_IND: dummy variable for industry.
2. Symbols *** and ** indicate statistically significant at the 1% and 5% levels, respectively.
120 Management Review, July 2013
Table 2
Results from Regressions of Stock Price on Earnings, Book Value
and Two Interactive Variables for the Enforcement of SFAS
No.34-Robustness Testing
Dependent Variable (P)
Explanatory Variables
Pooled regression with
Pooled regression without
industrial-dummy
industrial-dummy
Panel A Excluding sample firms with negative equity book value
D_34*EPS
-5.05**
(t=-2.10)
-5.08**
(t=-2.12)
D_34*BV
0.56***
(t=2.61)
0.57***
(t=2.64)
D_34*EPS
-0.09*
(t=-1.83)
-0.09*
(t=-1.81)
D_34*BV
0.38***
(t=3.22)
0.39***
(t=3.13)
Panel B Total assets scaling examination
Panel C-1 Excluding the non-financial instruments users---balance sheet approach
D_34*EPS
-4.91**
(t=-2.11)
-4.93**
(t=-2.13)
D_34*BV
0.62***
(t=2.91)
0.62***
(t=2.89)
Panel C-2 Excluding the non-financial instruments users---income statement approach
D_34*EPS
-5.70***
(t=-2.73)
-5.68**
(t=-2.75)
D_34*BV
0.66***
(t=3.02)
0.65***
(t=2.98)
Panel D Controlling the effect of SFAS No.35 examination
D_34*EPS
-4.98**
(t=-2.10)
-5.00**
(t=-2.12)
D_34*BV
0.59***
(t=2.77)
0.59***
(t=2.78)
Panel E Incorporating interactive control variables examination
D_34*EPS
-5.15**
(t=-2.15)
-5.15**
(t=-2.17)
D_34*BV
0.59***
(t=2.78)
0.60***
(t=2.78)
Legends:
1. Variables are defined in Table 1.
2. Symbols ***, **, and * indicate statistically significant at the 1%, 5%, and 10% levels, respectively.
Effect of SFAS 34 on Value-Relevance
121
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