Third Financial Reporting Workshop
Naples, June 14th-15th 2012
Market reaction to the consolidation of JCEs in the Italian listed companies
Simona Catuogno
Associate professor – University of Naples Federico II –
Via Cinthia - Montesantangelo
simona.catuogno@unina.it
Alessandra Allini
Assistant professor – University of Naples Federico II
Via Cinthia - Montesantangelo
alessandra.allini@unina.it
Ingrid Pulcinelli
Phd student – University of Naples Federico II
Via Cinthia - Montesantangelo
ingridpulcinelli@virgilio.it
1
The market reaction to the consolidation of JCEs in Italian listed companies:
evidences from the current financial reporting convergence
Abstract
Our paper intends to analyze the relation between the comparability of financial statements and the
market reaction to the differing accounting choices for the consolidation of interests in joint controlled
entities (JCEs). Assuming that differences between the Proportionate consolidation and the Equity
method on the financial statement of the venturer mainly refer to the total assets, total liabilities,
total revenues and total expenses, without changes in terms of equity and net income, we formulate
some starting assumptions. Considering the previous literature and the assumptions above, the
current study aims to contribute to the literature by exploring the following main research question:
which is the market reaction on price/earnings deriving from the two different accounting
treatments? To provide first results, we are going to measure accounting comparability through
Herfindhal index related to the differing accounting choices for the consolidation of interests in joint
controlled entities (JCEs), hence we conduct a descriptive analysis, whose aim is to describe the
distribution of the 21 Italian groups, each years from 2004 to 2010 based on two parameters,
price/earnings and method of consolidation for JCE’s, with the purpose to verify if the market is
able to capture the above mentioned lack of comparability deriving from a multiple accounting option.
Keywords: joint controlled entities, equity and proportionate method, multiple options, comparability,
price/earnings
2
INTRODUCTION
Harmonized accounting standards do not necessarily lead to harmonized accounting practices,
especially when multiple evaluation options are allowed by international accounting rules.
In our previous research on the consolidation of investments in subsidiaries, associates, joint
ventures and other equity interests (Catuogno and Allini, 2011), we observed a decrease in the level
of comparability among Italian and Spanish financial statements when the single financial
accounting principles provide multiple evaluation options.
In particular, the alternative between the Proportionate consolidation and the Equity method in the
accounting for joint controlled entities (JCEs) undermines the comparability of the accounting practices.
Our results suggest that the alternative between the Proportionate consolidation and the Equity
method undermines the comparability of the accounting practices.
Consistently with what we claimed, on May 2011 the IASB issued IFRS 11, Joint Arrangements,
with the main purpose to increase comparability within IFRS by removing the choice for JCEs to
use Proportionate consolidation. Instead, JCEs that meet the definition of a joint venture must be
accounted for using the Equity method. This also converges with US GAAP, which generally
requires the Equity method for joint ventures.
Starting from this findings, we intend to develop our research by focusing on the interest in JCEs
held by Italian listed group, extending our survey to the data of the consolidated financial
statements for the period which goes from 31/12/2004, the last pre-IAS/IFRS year, to 31/12/2010.
On this basis, in order to present a contribution to the accounting literature debate about the
relationship between the comparability of financial statements and the market reaction to the
differing accounting choices, we mean to provide an answer to the following main research
question: “which is the market effect, measured in terms of price/earnings, resulting from the
choices of the Italian listed groups in the accounting for JCEs with the Equity or the Proportionate
method?”. The observed item refers to the accounting for interests in joint controlled entities
3
(JCEs), since as Soonawalla (2006) noted, there was little literature on thus topic and International
Accounting Standards Setters recently focus on identifying the appropriate accounting method.
Accordingly, first of all, we intend to conduct an empirical investigation to measure the
comparability for the consolidation of the interests in JCEs related to the accounting choices made
by a selected sample of 21 non financial Italian listed groups through the use of the van der Tas
Herfindahl H index, since it is very simple, very easy to use and particularly suitable for the
measurement of the comparability within one Country.
Consequently, presuming that differences between the Proportionate consolidation and the Equity
method on the financial statement of the venturer, mainly refer to the total assets, total liabilities,
total revenues and total expenses, without changes in terms of equity and net income, we formulate
some starting assumptions as illustrated in the subsequent section 3.
Finally, with the purpose to provide first results, we conduct a descriptive statistic analysis, whose
aim is to describe the distribution of the 21 Italian groups, in each years from 2004 to 2010, based
on two parameters:
1) price/earnings and
2) method of consolidation for JCE’s,
with the final objective to verify if the market is able to capture the above mentioned lack of
comparability, as measured by the price/earnings ratio.
First results show that the market seems not able to capture the lack of comparability, since seems
to reward the firms adopting the Equity method in the consolidation of their interests in JCEs,
which present, as result, higher values of the ROI and the ROS, and lower values of Leverage.
The paper is structured as follows. Section 1 present the literature review, section 2 provides a
summary of the accounting for jointly controlled entities, section 3 describes the methodology, the
assumptions and the research question, section 4 describes sample and data collection, section 5
shows results and section 6 concludes.
4
1. LITERATURE REVIEW
1.1
THE ACCOUNTING COMPARABILITY
With the mandatory introduction of the International Accounting Standards/International Financial
Reporting Standards (hereafter IAS/IFRS), a fundamental step has been taken towards
comparability among countries with different accounting traditions in the preparation of
consolidated financial statements.
In the present paper we intend the comparability as the harmonization of the accounting practices.
In the accounting literature, the harmonization has been researched in terms of the standards that
have been adopted, or in terms of the accounting behaviours (Nair and Frank, 1980; Tay and Parker,
1990; Fontes et al., 2005; Ding et al., 2007; Jaafar and McLeay, 2007).
In the first case, we deal with a process which leads to the harmonization of the accounting
standards. This interpretation has been called de jure harmonization (van der Tas, 1992).
In the second case, instead, the harmonization of accounting choices does not depend on the
existence of a same set of accounting principles. The de jure harmonization is usually expected to
lead to the de facto harmonization, however this is not always true. As a matter of fact, the
mandatory application of the same set of accounting rules does not necessarily lead to comparability
intended as harmonization in the accounting practices, because companies could still choose
divergent accounting behaviours, especially in the case of standards that offer multiple options for
the valuation of the same items, each of which is compliant with the standard (Land and Lang,
2002). Consequently, the pursuing of the comparability is entrusted to the standard setting process,
as well as to the practical application of the standards themselves (Thorsten and GornikTomaszewski, 2006; Jagannath and Nanjegowda, 2008; Paananen and Henghsiu, 2009).
Moreover, previous studies confirmed the existence of factors, other than regulations, that can affect
both the accounting practices and the value relevance of accounting information (Alexander and Nobes,
2007; Nobes et al., 2008; Cairns et al., 2011).
The existing literature investigated accounting harmonization (rectius accounting comparability) by
5
assuming different perspectives. Raham et al. (2002; 5) classified this contributes in six main categories.
The first group examines accounting practices and regulations as well as the environmental factors that
influence them in different countries (e.g. Nobes, 2006; Radebaugh and Gray, 1993).
The second group focuses mainly on different aspects of regulation (e.g. Adhikari and Tondkar, 1992).
The third group analyses accounting practice harmony at a point in time and accounting practice
harmonization, through measurement of movements in harmony over a period of time (e.g. Nair and
Frank, 1981; Evans and Taylor, 1982).
The fourth group examines the relation between accounting practice harmonization and key financial
ratios (Weetman and Gray, 1990; Hellman, 1993).
The fifth group considers the concerns about accounting practice harmony measurement techniques
raised in the literature and tried to improve the methodology in that respect (Tay and Parker, 1992; van
der Tas, 1992).
Finally, the last group analyzes the association of practice harmonization and market reaction.
In particular, some papers captured share prices as market reaction (Alford et al., 1993; Amir et al:
1993; Barth and Clinch, 1996; Harris et al., 1994), while Ball et. al (1998) observed the market
relevance of accounting earnings in common-law and code-law countries and found different
institutional factors that can influence the value relevance of earnings in the two types of countries.
The work introduced a means of testing the influence of environmental variables on at least one
outcome of accounting, market reactions to accounting information.
Our paper fills in this last group of studies. We intend to contribute to this debate by analyzing the
relation between accounting comparability and market reaction to the differing accounting choices
related to interests in joint controlled entities (JCEs). Soonawalla (2006) noted there was little
literature on it and International Accounting Standards Setters recently focus on identifying the
appropriate method encouraging researchers to perform empirical findings into the way the
standards are considered into economic decision.
6
1.2
THE CONSOLIDATION OF JOINTLY CONTROLLED ENTITIES
Empirical findings revealed that International Accounting Standards offering multiple options for
the valuation of the same items decrease the comparability among financial statements (Mechelli,
2009; Morais and Curto, 2009). This is also the case for the consolidation of interests in JCEs as
IAS 31 provided two accounting treatments, the Proportionate consolidation and the Equity method.
In particular, our past study (Catuogno and Allini, 2011) showed that, during the period 2004–2009,
almost 50% of the Italian groups chosen the Equity method, probably because of the greater
simplicity of it, compared to the complexity of the Proportionate method, despite the IASB
recommended the Proportionate consolidation in IAS 31 which better reflects the economic
substance of the interests in jointly controlled entities.
The recent issue of IFRS 11 eliminates the problem of this multiple option, confirming only the
Equity method to account for JCEs.
However literature does not provide convincing evidence on the superiority of one method over
another. The first contributes supporting the Equity method focuses on the lack of a theoretical basis
for recording the proportionate share of joint venture accounts because resources subject to joint
control do not fit with the traditional definitions of assets and liabilities.
In a past study, Milburn and Chant (1999) conclude that the Equity method is the more appropriate,
primarily because jointly controlled assets and liabilities do not comply with the control criterion
required for full consolidation with the venturer. It complies with a so called legal model (Stoltzfus
and Epps, 2005). Supporters of the Equity method also point out that if the venturer does not
guarantee the liabilities of the joint venture and does not otherwise have an obligation for them, the
debt should not be recognized in the venturer’s financial statement (Milburn and Chant 1999, 3-12).
As the venturer is not ultimately responsible for debts, the venturer should not disclose the debt, as
if it was their obligation.
Moreover, proponents of the Equity method argue also that Proportionate consolidation determines
financial statements that might be not easy to analyse and interpret for a potential investor and
7
comparability would be affected. Bierman (1992, p. 15) noticed that “the primary disadvantage of
proportionate consolidation is that accounting complexities are introduced compared to just
showing an investment in common stock”.
On the other hand, the primary arguments for Proportionate consolidation reflect the assumption
that it provides more useful information compared to the Equity method’s single line presentation. It
complies with a so called implicit model (Stoltzfus and Epps, 2005).
In this direction, Graham et al. (2003) compare the two methods revealing that Proportionate
consolidated financial statements are more useful in predicting future returns on shareholders’
equity than the Equity method. He found a stronger relation between current and prior-year
components of return on equity and current year stock returns as well a stronger relation between
return on common shareholders’ equity and prior-year disaggregated components (profit margin,
asset turnover, and the leverage ratio).
An empirical investigation in the Australian real estate industry sector suggests that, in practice,
venturers chose the Proportionate method when the joint venture debt was recourse and the Equity
method when the joint venture debt was non-recourse (Whittred and Zimmer, 1994). Moreover,
there is some findings that venturer bond raters will include joint venture liabilities with the
venturer’s liabilities to the extent the joint venture liabilities are contingently guaranteed by the
venturer (Bailey Wendy, 2001).
Then, among studies on accounting for JCEs, there are few contributes examining the relation
between an adopted method and the market reaction. In particular, prior research documents an
association between joint venture investments and share prices (Koh and Venkatraman, 1991;
Madhavan and Prescott, 1995; Park and Kim, 1997), even if without monitoring whether joint
venture accounting amounts are associated with share prices.
Maines et al. (2000) investigated whether analysts give different equity values depending on
whether a firm adopts the Equity or Proportionate method to account for joint venture interests.
They find that analysts with low familiarity in joint venture accounting rules assigned higher equity
8
values to firms with Equity method financial statements than to firms with proportionally
consolidated financial statements. Their study supported the idea that aggregating joint venture
accounting amounts leads to loss of value relevant information.
Kothavala (2003) tests the risk relevance of joint venture accounting amounts and ratios for a
sample of Canadian firms and finds that disaggregated information on joint venture accounting
amounts helps explain variation in market risk.
Lim et al (2003) highlight that the Equity method supports relevant information for users.
Stoltzfus and Epps (2005) examine whether bond risk premiums are more highly associated with
accounting numbers from Proportionate consolidation than Equity method accounting: findings
show a higher correlation to the Equity method of accounting.
As noted above, evidences show mixed results.
2. THE ACCOUNTING FOR JOINTLY CONTROLLED ENTITIES IN IAS/IFRS AND IN ITALIAN GAAP
The consolidation of interests in joint ventures raises a relevant problem of harmonization and
comparability, with both conceptual and operational implications.
Since Italian regulation does not provide a specific definition of joint venture, neither specifically
addresses the different types of agreement which characterize the joint ventures, we consider the
International regulation as a benchmark also for the national perspective in the accounting for the
interests in joint ventures.
Starting form 2005, with the mandatory introduction of the IAS/IFRS, all the companies adopting
such principles have been applying IAS 31 for the accounting of interests in joint venture.
IAS 31 classifies joint arrangements into three broad categories: jointly controlled operations
(JCOs), jointly controlled assets (JCAs) and jointly controlled entities (JCEs), prescribing different
accounting method for each type of joint venture.
According to IAS 31, it is possible to identify a JCOs (par. 13) “when the operation of some joint
ventures involves the use of the assets and other resources of the venturers rather than the
9
establishment of a corporation, partnership or other entity, or a financial structure that is separate
from the venturers themselves”; JCAs (par. 18) “when the operation of some joint ventures involves
the joint control, and often the joint ownership, by the venturers of one or more assets contributed
to, or acquired for the purpose of, the joint venture and dedicated to the purposes of the joint
venture” and finally a JCEs (par. 24) “when the joint venture involves the establishment of a
corporation, partnership or other entity in which each venturer has an interest”.
Regarding the accounting for the interests in JCEs, the International standards allow the recognition
of investments held in JCEs, in the venturer financial statement, through one of the two methods
between the Proportionate consolidation or the Equity method.
On the other hand, the Italian regulation (Decree n. 127/1991 art. 33) prescribes the application of
the Equity method if the company decides not to consolidate the JCEs, and the Proportionate
method for the consolidation of JCEs.
The impact on venturer financial statement will be different according to the accounting method
chosen. In particular, under the Proportionate method a venturer’s share of each of the assets,
liabilities, revenues and expenses of a JCEs is combined line by line with similar items in the
venturer’s financial statements or reported as separate line items in the venturer’s financial
statements. Otherwise, under the Equity method an interest in a JCEs is initially recorded at cost
and thereafter adjusted for the post-acquisition change in the venturer’s share of net assets of the
JCEs.
Since that, the Board considers the multiple evaluation options allowed by IAS 31 as an
impediment to high quality reporting of joint arrangements, and in order to reduce differences
between IFRSs and US GAAP, it was necessary a project to replace IAS 31.
As a result, the IFRS 11 Joint Arrangements was published in May 2011 by the IASB as part of its
new suite of consolidation and related standards, also replacing existing requirements for
subsidiaries. The standard will be applied starting from 2013. The Board proposes to use ‘joint
arrangement’, rather than ‘joint venture’, to describe joint activities subject to the requirements of
10
the IFRS. According to IFRS 11, the classification of the joint arrangement depends on whether
parties have rights to and obligations for underlying assets and liabilities rather.
The new standard carves out cases in which although there is a separate vehicle, that separation is
ineffective in certain ways. These arrangements are treated similarly to jointly controlled
assets/operations under IAS 31 and are now called joint operations.
Furthermore, the remainder of IAS 31 jointly controlled entities, now called joint ventures (JV),
does not allow the free choose between the Equity method or Proportionate consolidation; all
entities must now always use the Equity method. First explanations provided by the Standard Setter
showed that recognizing a proportionate share of each asset and liability of an entity was considered
not consistent with the Conceptual Framework (CF), which defines assets in terms of exclusive
control and liabilities in terms of present obligations. It leads to the recognition of amounts that do
not represent faithfully an entity’s assets and liabilities.
Then, in the Basis for Conclusions of IFRS 11, the main arguments supporting the elimination of
Proportionate method do not refer directly to the consistency of the CF, rather they refer to the
principles-based approach, to a better convergence with US GAAP and to a better verifiability,
comparability and understandability of the financial statement. IASB details the main effects for 19
companies related to the change of the Proportionate to the Equity accounting treatment on three
financial measures, assets, revenues and profitability and concluded that the adoption of IFRS 11
would have a little impact. (IASB, 2011a, p. 24).
3. THE METHODOLOGY: ASSUMPTIONS AND RESEARCH QUESTION
In our previous research on the consolidation of investments in subsidiaries, associates, joint
ventures and other equity interests in Italy and Spain, we observed a decrease in the level of
comparability – as measured trough the use of C index – among financial statements when the
single financial accounting principles provide multiple evaluation options (Catuogno, Allini, 2011).
11
In particular, the alternative between the Proportionate consolidation and the Equity method in the
accounting for JCEs undermines the comparability of the accounting practices.
As a matter of fact, our survey indicated that, during the period 31/12/2004 – 31/12/2009, almost
50% of the Italian groups chosen the Equity method, probably because of the greater simplicity of
that, compared to the complexity of the Proportionate consolidation, despite the IASB
recommended the Proportionate method in IAS 31 which better reflects the economic substance of
the interests in JCEs.
Starting from these findings, we’ve developed our research by focusing on the interest in JCEs and
extending our survey to the data of the consolidated financial statements for the period which goes
from 31/12/2004, the last pre-IAS/IFRS year, to 31/12/2010.
On this basis, in order to present a contribution to the debate about the relationship between the
comparability and the market reaction to the differing accounting choices, we mean to provide an
answer to the following main research question: “which is the market effect, measured in terms of
price/earnings,resulting from the choices of the Italian listed groups in the accounting for JCEs
with the Equity or the Proportionate method?”.
Consequently, taking for granted that differences between the Proportionate consolidation and the
Equity method on the financial statement of the venturer mainly refer to the total assets, total
liabilities, total revenues and total expenses, without changes in terms of equity and net income, in
accordance with Graham et al (2003) and Bauman’s study (2007: 500) we formulate some starting
assumptions which are supported also by the following table of comparison referring to the
application of two accounting criteria.
The table below illustrates the impact on the financial statement of the venturer (Challenges in
adopting and applying IFRS 11, Ernst & Young, September 2011):
Table 1- Main
impacts on the financial statement of the venture
12
BALANCE SHEET
PROPORTIONATE CONSOLIDATION
EQUITY METHOD
320
2.100
2.420
(350)
(550)
(900)
(1.520)
—
1.520
1.520
—
—
—
(1.520)
PROPORTIONATE CONSOLIDATION
1.070
(840)
230
(125)
105
(25)
—
80
EQUITY METHOD
—
—
—
—
—
—
80
80
Current assets
Non-current assets
Total assets
Current liabilities
Non-current liabilities
Total liabilities
Total equity
INCOME STATEMENT
Revenue
Cost of sales
Gross margin
Other operating costs
Operating profit
Interest and taxes
Share of profit from joint ventures
Net income
The followings are our starting assumptions:
Assumption 1. The comparability of financial statements decreases as a consequence of different
accounting choices provided by IAS 31.
Assumption 2. The comparability of some key performance metrics decreases as a consequence of
different accounting choices provided by IAS 31.
Starting from the assumption n. 2, we also assume that:
Assumption 2.1) The ROI is higher under the application of the Equity method than under the
application of the Proportionate consolidation;
Assumption 2.2) The Leverage, as measured in terms of in term of Loans/Equity, is lower under the
application of the Equity method than under the application of the Proportionate consolidation;
Assumption 2.3) The ROS is higher under the application of the Equity method than under the
application of the Proportionate consolidation.
Accordingly, first of all, we conduct an empirical investigation to measure the comparability for the
consolidation of the interests in JCEs, through the use of the van der Tas Herfindahl H index.
13
Hence, we conduct a statistic analysis, whose aim is to describe the distribution of the Italian groups
selected, in each years from 2004 to 2010, based on two parameters:
1) price/earnings and
2) method of consolidation for JCE’s,
with the objective to verify if the market is able to capture the above mentioned lack of
comparability, as measured by the price/earnings ratio, presuming that both the financial statements
of the 21 Italian listed groups and their related key performance metrics are not comparable.
3.1 MEASURING COMPARABILITY
Several methods have been developed to measure the comparability of financial reporting and,
among them, we can distinguish between the indices and the statistical models. These methods
cannot be used interchangeably since they measure different concepts of ‘comparability’ and
‘harmony’. Van der Tas was one of the first researchers who used indices to measure the
comparability of financial statements. According to van der Tas (1988), two financial reports are
comparable to one specific event if this event, under the same circumstances, is accounted for in the
same way in both reports or if multiple reporting takes place. Van der Tas uses indices because he
believes that maximum harmony is reached when all companies select the same accounting method.
On the other hand, McLeay et al. (1999) use a statistical model because they believe that
harmonization takes place when there is an increasing similarity in the distribution of the
probability that a particular accounting method is used. These researchers argue that it is the
availability of alternative accounting treatments and the use by individual firms of the appropriate
method that produces comparable financial statements.
Most of the papers which deal with the area of financial accounting harmonization have mainly
been focused on the use of indices. Van der Tas introduced the Herfindahl index (H index) in 1988
(than adjusted by Hirschman) as a measure of the comparability of financial statements.
Then, in order to facilitate the comparison among countries, van der Tas (1988; 1992) introduced
14
the I index and the Comparability or C index, the last one in the two versions: within and betweencountries. H and C index can be used to measure harmony within individual countries while I and
“C index between countries” can be used to measure harmony between two or more countries. In
particular, Archer et al. (1995) decomposed the C-index into within-country and between-country
components and then (Archer et al., 1996) developed their methodology by using log–linear models
Within the harmonization literature, other measurement instruments have been proposed (Mustata et
al., 2011). Ashbaugh & Pincus (2001) use the Method index to capture differences between
accounting standards and IFRS across countries due to differences in measurement methods.
Garrido et al. (2002) test the application of the Euclidian distances (as an econometric tool) to the
level of the de jure harmonization achieved by the IASB.
Still assuming the instruments based on the measurement of the Euclidian distance, recent studies
have formulated an innovative index – the ED index – (MustaŃă & Matis, 2010), with the purpose
of considering the comparison between succeeding temporal measurements, even when the number
of observed items changes over time.
Furthermore, starting from the assumption that the Euclidian distance allows “temporal”
comparisons only if the number of the considered variables is constant from one period to another,
Fontes et al. (2005) propose to make use of Jaccard’s and Spearman’s coefficients with the aim of
measuring the level of comparability between the IAS/IFRS and certain domestic accounting
standards in the case of Portugal.
As noted, literature offers a big variety of methods to measure comparability.
Among them, the H index developed by van der Tas (1988) has been used. Trough this method is
possible to determine when and to what extent harmonization has taken place subsequently the
introduction of new mandatory provisions (van der Tas, 1988). The H index is simply and is
particularly indicated for the measure of the harmonization within a single country. It is calculated
by weighting the relative frequencies of the alternative opinions against each other, the relative
frequency is the number of parties choosing a particular method divided by the total number of
15
parties. The formula of H Index is:
H 
n

i 1
pi2
Where:
H = Herfindahl index;
n = the number of alternative accounting methods;
pi = the relative frequency of accounting method i.
The H index can varies between 0 – there is no harmony - and 1 – all companies use the same
accounting method.
4. SAMPLE AND DATA COLLECTION
Our empirical survey has been conducted considering all Italian listed industrial groups holding
interests in JCEs for the period 2004-2010, with the exception of the companies that belong to the
FTSE Italia Finanza, FTSE Italia Banche, FTSE Italia Assicurazioni, FTSE Italia Servizi Finanziari.
Furthermore, we decide to exclude IPO companies listed after 31/12/2004, in order to make the
sample homogeneous, and MTA International sector groups, in order to keep the IAS/IFRS
conformity tests fair.
Non-operating holding companies were also excluded, as they were not representative.
Finally, still aiming at keeping the sample homogeneous, we excluded all the companies whose
financial statement date differed from the 31st of December and the groups which became
operational, or derived from extraordinary transactions such as mergers or acquisitions, during the observation period. Moreover some companies were excluded because their consolidated financial
statements were not available or not legible.
As a result, we extracted a sample of 21 firms holding interest in JCEs, that are listed on the Italian
Stock Exchange during the whole period of observation.
Starting from our data collection, we applied the H index to the selected sample.
16
Thereafter, in order to observe the market reaction deriving from the selected accounting method,
we collected the price/earnings ratio, at the end of each years, for each of the firm included in our
sample; we employed two database, Datastream and Mediobanca.
Price earning ratio has been considered in literature as a good proxy for market reaction (see, for all
Basu, 1977). Many contributions focus on the value intervals that P/E ratio can assume, since it
depends by many factors: in our study we assume three value intervals, according to a historical
table provided by Shiller (2005):
1) the interval “P/E<15”, includes the stocks which are undervalued by the market and are less
expensive;
2) the interval “15<P/E<25”, includes the stocks which are expressed at their “fair value”. This
interval has been considered “fair” and assumed as benchmark;
3) the interval “P/E>25”, includes the stocks which are overvalued and are more expensive.
5. RESULTS
The present research seems to confirm our previous study (Catuogno & Allini, 2011) in terms of
the comparability of financial statements for JCEs, as showed in the table below.
Table 2 - The comparability for investments in joint ventures
H index
2010
Frequence
H
2009
Frequence
H
Data
2008
Frequence
H
12
9
0,57
0,43
0,33
0,18
12
9
0,57
0,43
0,33
0,18
10
11
0,46
0,52
0,21
0,27
21
0,51
Data
1,00
H index: 0,51
2007
Frequence
21
0,51
21
H
Data
1,00
H index: 0,48
2005
Frequence
0,48
Data
1,00
H index: 0,51
2006
Frequence
H
10
11
0,48
0,52
0,23
0,27
10
11
0,48
0,52
0,23
0,27
11
10
0,52
0,48
0,27
0,23
21
0,50
21
1,00
H index: 0,50
0,50
21
1,00
H index: 0,50
0,50
Data
1,00
H index: 0,50
2004
Frequence
13
8
0,62
0,38
0,38
0,15
21
1,00
H index: 0,53
0,53
Data
Consolidation method
Proportionate
Equity
Both
H index
Consolidation method
Proportionate
Equity
Both
H index
Consolidation method
Proportionate
Equity
Both
Data
H
17
H
In particular, our survey indicates that, during the observed period, almost 50% of the Italian groups
chosen the Equity method, probably because of the greater simplicity of that, compared to the
complexity of the Proportionate method, despite the IASB recommended - before the issue of IFRS
11 –the Proportionate consolidation in IAS 31, which better reflects the economic substance of the
interests in jointly controlled entities.
Our findings document that despite the accomplishment of the maximum level of de jure
harmonization and even if the firms fully comply with the international accounting rules, the
comparability in Italy still remains at a medium level (about 0,50) since the companies can choose
between the two accounting choices.
As a consequence, the comparability of the main key performance metrics (ROI- ROS- Leverege)
decreases as a result deriving from the application of different accounting choices provided by IAS
31.
By taking into account this medium level of comparability, we try to investigate the market effect,
captured in terms of price/earnings ratio, resulting from the choices in the accounting for JCEs with
the Equity or the Proportionate method.
Results are summarized in the tables below (we show “not applicable” – N/A – in all the cases in
which firms have a undefined P/E ratio or when data were not available).
Table 3 – Market reaction and comparability for JCEs in 2004
Market Reaction 2004
100
75
50
P/E
25
Equity Method
Proportionate Method
Accounting Method
Table 4 – Market reaction and comparability for JCEs in 2005
18
Stefanel
Save
Finmeccanica
Prima
Industrie
Saes Getters
Eni
Enel
Edison
Buzzi Unicem
Autogrill
Astaldi
Actelios
Acea
Pininfarina
Rcs
Mediagroup
Telecom
Italia
Trevi Fin
Brembo
Bulgari
Davide
Campari
Fiat
n/a
0
0
n/a
19
Equity Method
Accounting Method
Proportionate Method
Trevi Fin
Save
Finmeccanica
Enel
Edison
Buzzi Unicem
Equity Method
Bulgari
Trevi Fin
Save
Finmeccanica
Enel
Edison
Buzzi Unicem
Bulgari
Autogrill
Actelios
Acea
Telecom Italia
Stefanel
Saes Getters
Rcs Mediagroup
Prima Industrie
Equity Method
Autogrill
Actelios
Acea
Telecom
Italia
Stefanel
Saes Getters
Prima
Industrie
Rcs
Mediagroup
Pininfarina
Fiat
Eni
Davide Campari
Brembo
Astaldi
0
Pininfarina
Fiat
Eni
Davide
Campari
Brembo
Astaldi
Trevi Fin
Save
Saes Getters
Finmeccanica
Enel
Edison
Buzzi Unicem
Bulgari
Autogrill
Actelios
Acea
Telecom
Italia
Stefanel
Prima
Industrie
Rcs
Mediagroup
Pininfarina
Fiat
Eni
Davide
Campari
Brembo
Astaldi
Market Reaction 2005
100
75
50
P/E
25
0
Accounting Method
proportionate method
Table 5 – Market reaction and comparability for JCEs in 2006
Market Reaction 2006
100
75
50
25
P/E
n/a
Accounting Method
proportionate method
Table 6 – Market reaction and comparability for JCEs in 2007
Market Reaction 2007
100
75
50
25
P/E
20
Equity Method
Accounting Method
Proportionate Method
Trevi Fin
Save
Saes Getters
Finmeccanica
Eni
Enel
Trevi Fin
Save
Saes Getters
Finmeccanica
Eni
Enel
Edison
Buzzi Unicem
Bulgari
Autogrill
Actelios
Acea
Equity Method
Edison
Equity Method
Buzzi Unicem
Bulgari
Autogrill
Actelios
n/a
Stefanel
Trevi Fin
Save
Finmeccanica
Enel
Edison
Buzzi Unicem
Bulgari
Autogrill
Actelios
Acea
Telecom
Italia
Stefanel
Saes Getters
Prima
Industrie
Rcs
Mediagroup
Pininfarina
Fiat
Eni
Davide
Campari
Brembo
Astaldi
n/a
Acea
n/a
Telecom
Italia
n/a
Stefanel
Prima
Industrie
Rcs
Mediagroup
Pininfarina
Fiat
Davide
Campari
Brembo
Astaldi
0
Telecom
Italia
n/a
Prima
Industrie
Rcs
Mediagroup
Pininfarina
Fiat
Davide
Campari
Brembo
Astaldi
Table 7 – Market reaction and comparability for JCEs in 2008
Market Reaction 2008
100
75
50
25
P/E
n/a
Proportionate Method
Accounting Method
Table 8 – Market reaction and comparability for JCEs in 2009
Market Reaction 2009
100,0
75,0
50,0
25,0
P/E
0,0
n/a
Accounting Method
Proportionate Method
Table 9 – Market reaction and comparability for JCEs in 2010
Market Reaction 2010
100
75
50
25
P/E
0
n/a
Despite Graham et al. (2003) found that Proportionate consolidation should be considered an
appropriate method of accounting for joint ventures and Bauman (2007) indicated that pro forma
proportionate consolidated financial statements have greater relevance than Equity method for the
explaining of bond ratings, our results show that when accounting comparability in the accounting
for JCEs is not achieved, due to the presence of multiple evaluation options, a different effect on the
market seems to be produced.
During the years 2004, 2005 and 2010, we observe the highest (overvalued) levels of P/E ratio
when the Proportionate criteria is applied. Only in the year 2008, the P/E ratio related to all the
observed firms is undervalued probably as a result of the beginning of the financial crisis: however,
the undervaluation appears to be higher for firms adopting the Equity method.
Therefore, we can argue that the accounting evaluation choice produces a significant market effect.
In particular, results show that the P/E ratio, as a measure to capture the market effect, appears to be
fairer in firms adopting the Equity method instead of the Proportionate method. The market seems
not able to capture the above mentioned lack of comparability of both, the financial statements and
the key performance indicators, that derives from the multiple accounting option provided by IAS
31. In particular, the stock market, as reflected in terms of price/earnings, seems to reward the
firms adopting the Equity method in the consolidation of their interests in JCEs and that, as result,
present higher values of the ROI and the ROS, and lower values of Leverage. In order to confirm
our empirical observations, further investigation have to be conducted in order to verify a
correlation between the accounting method and the market reaction.
6. Conclusions
Our paper intended to analyze the relation between the comparability of financial statements and the
market reaction to the differing accounting choices provided in the consolidation of interests in joint
controlled entities (JCEs). In particular, the current study aimed to explore the market reaction as
21
captured by the price/earnings ratio deriving from the two different accounting treatments related to
the JCEs.
Firstly to obtain the results, we selected a sample of 21 Italian firms holding interest in JCEs, that
are listed on the Italian Stock Exchange during the whole period of observation which goes from
2004 to 2010.
First of all, we measured the level of accounting comparability through the Herfindahl H index:
evidences provided that the level of comparability is still medium for all this item, despite all firms
comply with IAS 31.
Our empirical findings contribute to the literature debate on the accounting comparability by
confirming that harmonized accounting standards do not necessarily lead to harmonized accounting
practices and comparability (e.g. Paananen and Henghsiu, 2009; Jagannath and Nanjegowda, 2008).
Results are consistent with previous studies focused on other specific items (Mechelli, 2009; Cairns
et al., 2011) and highlight the existence of factors, other than regulations, that can affect both the
accounting practices and the value relevance of accounting information (Nobes, 2006; Morais &
Curto, 2009; Zeff, 2007).
Hence, by considering this finding, we formulate some starting assumptions following Bauman and
Graham studies (2007; 2003) and we conducted a statistic descriptive analysis whose aim is to show
the distribution of the selected 21 Italian groups, in each years from 2004 to 2010, based on two
parameters: price/earnings ratio and method of consolidation (Equity and Proportionate) for JCE’s.
Our results show that the price earnings ratio – as a measure to capture the market reaction –
appears to be fairer for firms adopting the Equity method instead of the Proportionate method and
in particular the market seems to reward the firms adopting the Equity method in the consolidation
of their interests in JCEs and that, as result, present higher values of the ROI and the ROS, and
lower values of Leverage.
Finally our research presents some limitations.
The first limit is linked to the analysis of the comparability of financial statement on an item by
22
item base. The extension of the test of comparability to other transactions and items would have
concurred to enhance the actual obtained results.
The second limit regards the consideration of the P/E ratio; other performance ratios should be
included in order to test if a particular accounting method is associated with decision outcomes.
Therefore, a correlation analysis is required in order to capture and measure which factors could
support the consistency of the Equity method.
Thus the future research will focus on:
1. A simulation of the transition from the Proportionate consolidation to the Equity method for all the
selected Italian groups, as required by IFRS 11;
2. the adoption of a multi-regression analysis between selected performance ratios deriving from
the mentioned transition and the market reaction in order to test the consistencyinconsistency of the Equity method.
References
Alexander, D., and Nobes, C. (2007). Financial Accounting: An International Introduction, London:
Prentice Hall.
Adhikari, A., and R. H. Tondkar, (1992). Environmental Factors Influencing Accounting Disclosure
Requirements of Global Stock Exchanges, Journal of Internationat Financial Management and
Accounting, Vol. 4, No. 2, pp. 75- 105.
Alford, A., J. Jones, Leftwich, R., and Zmijewski, M. (1993). The Relative Informativeness of Accounting
Disclosures in Different Countries, Journal of Accounting Research, Vol. 31, pp 183-223.
Amir, E., Harris, T.S., and Venuti, E. K. (1993). A Comparison of the Value Relevance of U.S. Versus
Non- U.S. GAAP Accounting Measures Using Form 20-f Reconciliations, Journal of Accounting
Research, Vol. 31, pp. 230-264.
Archer, S., Delvaille, P., and Mcleay, S. (1995). The Measurement of Harmonization and Comparability
23
of Financial Statement Items: Within – Country and Between - Country Effects , Accounting and
Business Research, Vol. 25, No. 98, pp. 67-80.
Archer, S., Delvaille, P., and Mcleay, S. (1996). A Statistical Model of International Accounting
Harmonization, Abacus, Vol. 32, No. 1, pp. 1-29.
Ashbaugh, H., and Pincus, M. (2001). Domestic Accounting Standards, International Accounting Standards,
and the Predictability of Earnings. Journal of Accounting Research, Vol. 36, No. 3, pp. 417- 432.
Bailey Wendy J. (2001). The impact of joint venture accounting methods and the guarantee of joint venture
debt on corporate lending decisions and debt covenant restrictions. Working paper. University of
California Riverside.
Ball, R., Kothari, S., and Robin, A.(1998). The Effect of International Institutional Factors on Properties of
Accounting Earnings, paper, William E. Simon Graduate School of Business Administration, University
of Rochester.
Barth, M. E., and Clinch, G. (1996). International Accounting Differences and Their Relation to Share
Prices: Evidence for U.K., Australian and Canadian Firms, Contemporary Accounting Research, Vol.
13, No. 1, pp. 135-170.
Barth, M. E., Clinch, G., and Shibano, T. (1999). International Accounting Harmonization and Global
Equity Markets, Journal of Accounting and Economics, Vol. 26, No. 1-3, pp. 201-235.
Basu, I. (1977). Investment performance of common stocks in relation to their price-earnings ratios: A test
of the efficient market hypothesis, Journal of Finance, Vol. 32, No. 3, pp. 663-682.
Bauman M.P. (2007). Proportionate consolidation versus the equity method: additional evidence on the
association with bond rating, International Review of Financial analysis, Vol. 16, pp. 496-507.
Bierman, Jr.H. (1992). Proportionate consolidation and financial analysis, Accounting Horizons, Vol. 6,
pp. 5-17.
Cairns D., Massoudi D., Taplin, R., and Tarca, A. (2011). IFRS fair value measurement and accounting
24
policy choice in the United Kingdom and Australia, The British Accounting Review, Vol. 43, pp. 1–21.
Catuogno, S., and Allini, A. (2011). Multiple evaluation options & comparability: equity investments in
Italy and Spain, Accounting and Management Information Systems, Vol. 10, No. 2, pp. 249–274.
Costa Lourenço
I., Curto, J.D. (2010). Determinants of the accounting choice between alternative
reporting methods for interests in jointly controlled entities, European Accounting Review, vol. 19, no.
4, p. 739-773.
Ding, Y., Hope, O.K., Jeanjean, T., and Stolowy, H. (2007). Differences between Domestic Accounting
Standards and IAS: Measurement, Determinants and Implications, Journal of Accounting and Public
Policy, Vol. 26, No. 1, pp. 1-38.
Evans, T. G., and M. E. Taylor. (1982). '"Bottom-line Compliance" With the IASC: A Comparative
Analysis', International Journal of Accounting, Vol.18, No. 1, pp. 115-128.
Fontes, A., Rodrigues, L.L., and Craig, R. (2005). Measuring Convergence of National Accounting Standards
with International Financial Reporting Standards, Accounting Forum, Vol. 29, No. 4, pp. 415-36.
Garrido, P., Leòn, A., and Zorio, A. (2002). Measurement of formal harmonization progress:: The IASC
experience, The International Journal of Accounting, Vol. 37, No. 1, pp. 1-26.
Graham, R.G., King, R.D. and Morrill, C.K.J. (2003). Proportionate Consolidation vs. the Equity Method:
A Decision Usefulness Perspective on Reporting Interests in Joint Ventures, Accounting, Horizon, vol.
19, no 2, pp.1-29.
Harris, T., Lang, M., and Moller, H. (1994). The Value Relevance of German Accounting Measures: An
Empirical Analysis, Journal of Accounting Research, Vol. 32, No. 2, pp. 187-209.
Hellman, N., (1993). A Comparative Analysis of the Impaet of Accounting Differences on Profits and
Return on Equity: Differences Between Swedish Practice and US GAAP', European Accounting
Review, Vol. 2, No. 3, pp. 495-530.
Jaafar, A., and Mc Leay, S. (2007). Country Effects and Sector Effects on the Harmonization of
25
Accounting Policy Choice, Abacus, Vol. 43, No. 2, pp. 156-189.
Jagannath, K.M., and Nanjegowda, K. (2008). The Impact of Mandatory Accounting Standards on the
Harmonization of Accounting Practices, The International Journal of Accounting Research, Vol. 8, No.
1, pp. 7-23.
Koh, J., and Venkatraman, J. (1991). Joint Venture Formations and Stock Market Reactions: An
Assessment in the Information Technology Sector’, Academy of Management Journal, Vol. 34, No. 4,
pp. 869-893.
Kothavala, K. (2003). Proportionate consolidation versus the equity method: A risk measurement
perspective on reporting interests in joint ventures, Journal of Accounting & Public Policy, Vol. 22, No.
6, pp. 517-539.
Land, J., and Lang, M. (2002). Empirical Evidence on the Evolution of International Earnings, The
Accounting Review, Vol. 77, pp. 115–133.
Lim, C., Yeo C. and Liu C. (2003). Information asymmetry and accounting disclosures for joint ventures’,
International Journal of Accounting, vol. 38, pp. 23-39.
Madhavan, R., and Prescott, J. E. (1995). Market value impact of joint ventures: The effect of industry
information-processing load, Academy of Management Journal, Vol. 38, No. 3, pp. 900-915.
Maines, L. A., Mautz Jr., R. D., Wright, G. B., Yardley, J. A., Rosman A. J., and Graham L. E. (2000).
Implications of International Differences in Joint Venture Financial Reporting Standards for Financial
Analysts’ Stock Values. Working Paper.
McLeay, S., and Neal, D. (1999). International Standardization and Harmonization: a New Measurement
Technique, Journal of International Financial Management and Accounting, Vol. 1, No. 1, pp. 49-70.
Mechelli, A. (2009). Accounting Harmonization and Compliance in Applying IASB Standards: An
Empirical Survey about the First Time Adoption of IAS 7 by Italian Listed Groups, Accounting in
Europe, Vol. 6, No. 2, 231–270.
26
Milburn, J. A., and Chant., P. D.( 1999). Reporting interests in joint ventures and similar arrangements,
Financial accounting series special report, the FASB, Norwalk Connecticut.
Morais, A. I., and Curto, J. D. (2009). Mandatory Adoption of IASB Standards: Value Relevance and
Country-Specific Factors, Australian Accounting Review, Vol. 19, No. 2, pp. 128- 143.
MustaŃă , R., V., and Matis, D. ( 2010). Systems for material Harmonization measurement within the
changing global accounting environment: a review, Journal of Organisational Transformation and
Social Change, Vol. 7, No. 1, pp. 47- 48.
Nair, R.D., and Frank, G.W. (1980). The Impact of Disclosure and Measurement Practices on International
Accounting Classifications, The Accounting Review, Vol. 55, No. 3, pp. 426-450.
Nair, R. D., and W. G. Frank. (1981). “The Harmonization of International Accounting Standards 19731979”, International Journal of Accounting, Fall: 61-77.
Nobes, C. (2006). The Survival of international differences under IFRS: towards a research agenda.
Accounting and Business Research, Vol. 36, No. 3, pp. 233-245.
Nobes, C.W., Parker, R.B, and Parker, R.H. (2008). Comparative International Accounting, London:
Prentice Hall.
Oswald D., Zarowin P. (2007). Capitalization of R&D and the informativeness of stock prices. European
Accounting Review, 16, p. 703-7026
Paananen, M., and Henghsiu, L. (2009). The Development of Accounting Quality of IAS and IFRS over
Time: The Case of Germany, Journal of International accounting research, Vol. 8, No. 1, pp. 31-55.
Park, S., and Kim, D. (1997). Market Valuation of Joint Ventures: Characteristics and Wealth Gains,
Journal of Business Venturing, Vol. 12, pp. 18-108.
Radebaugh, L. H., and S. J. Gray. (1993). International Accounting and Multinational Enterprises, John
Wiley and Sons.
Rahman, A., Perera, H., and Ganesh, S. (2002). Accounting Practice Harmony, Accounting Regulation and
27
Firm Characteristics, Abacus, Vol. 38, No. 1, pp. 46-77.
Razvan, V. Mustata,V. R.,
Carmen G. Bonaci, G. C., Matis, D., and Strouhal, J. (2011). Using
Econometric Tools for Accounting Harmonization Measurement, International Journal of
Mathematical Models and Methods in applied sciences, Vol. 5, No. 2, pp. 316-323.
Shiller, R.J. (2005). Irrational Exuberance. Princeton: Princeton University Press.
Soonawalla A.K. (2006). Accounting for Joint venturers and associates in canada, U.K., and I.S.: do US
rules hide information?, Journal of Business Finance and Accounting, no. 3-4, pp. 395-417.
Stoltzfusa, R.L., Eppsb, R.W. (2005). An empirical study of the value-relevance of using proportionate
consolidation accounting for investments in joint ventures, Accounting Forum, Vol. 29, No. 2, pp. 169–
190.
Tay, J., and Parker, R. (1990). Measuring International Harmonization and Standardization, Abacus, Vol.
26, No. 1, pp. 71-88.
Tay, J. S. W. Parker R. H., and (1992). Measuring International Harmonization and Standardization: A
Reply, September. Abacus, Vol. 28, No. 2, pp. 217-220.
Thorsten, S., and Gornik-Tomaszewski, S. (2006). Implications of the IAS Regulation for Research into
the International Differences in Accounting Systems, European Accounting Review, Vol. 15, No. 3, pp.
187-217.
van der Tas, L.G. (1992). Evidence of EC Financial Reporting Practice Harmonization: The Case of
Deferred Taxation, European Accounting Review, Vol. 1, No. 1, pp. 69-104.
van der Tas, L. G. (1988). Measuring Harmonization of Financial Reporting Practice. Accounting and
business Research, Vol. 18, No. 70, pp. 157-169.
Weetman, P., and S. J. Gray,(1990). International Financial Analysis and Comparative Corporate
Performance: The Impact of U.K. vs. U.S. Accounting Principles on Earnings, Journal of International
Financial Management and Accounting, Vol. 2, No. 2-3, pp. 111-130.
28
Whittred, G., and Zimmer, I. (1994). Contracting cost determinants of GAAP for joint ventures in an
unregulated environment, Journal of Accounting and Economics, Vol. 17, No. 1-2, pp. 95-102.
Zeff, S.A. (2007). Some obstacles to global financial reporting comparability and convergence at a high
level of quality, The British Accounting Review, Vol. 39, pp. 290-302.
29