Civil war, stock return, and intellectual capital disclosure in Sri Lanka

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    ny nonan economic value to the rm (Skinner, 2ways of conceptualizing intellectual capitalconceptualize intellectual capital as the int

    that higher e96; Kleurcesave sug

    The future earnings of intellectual capital resources are more un-

    litical stability in the business environment where rms conduct their

    response to determine whether intellectual capital disclosure (ICD),

    Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 331337

    Contents lists available at SciVerse ScienceDirect

    Advances in Accounting, inInternational

    j ourna l homepage: www.e lcertain than assets shown on the nancial statement. The rights toownership of future earnings are less well dened for investmentsin intellectual capital resources than for assets shown on the nancialstatement (Lev, 2001). Inasmuch as intellectual capital resources areconsidered to entail variability in future earnings, policymakers con-sider that the level of uncertainty is greater for these resources thanfor assets shown on the nancial statement. This view is reected in

    which is considered as future earnings news by investors, was includedin the stock return of rms.

    The civil warwaswaged between the government of Sri Lanka and aseparatist guerrilla group,with the guerrillas attempting to break off thenorth and east regions of the country as a separate sovereign state. Theterror attacks were directed toward destroying government-owned in-frastructure such as roads, rail, airports, and seaports, and were seldomthe differential treatment, whereby intellectgenerally expensed (Barron, Byard, Kile, & R

    Tel.: +61 417 405 399.E-mail address:

    0882-6110/$ see front matter 2011 Elsevier Ltd. Alldoi:10.1016/j.adiac.2011.08.005earnings (Ashton, 2005; 1998). The short-term view taken by investors on rm performanceduring this period became an ideal subject for investigation of investorsure can inform investors about rms' futureBeattie, 1999; Lev, 2001).create economic value, many studies hcounted for on the balance sheet andtured, and leveraged to produce a h(CMA, 1998; Edvinsson & Sullivan, 19tellectual capital is a collection of reso008). There are several, and one of them is toellectual material unac-as been formalized, cap-conomic value of rmsin, 1998, p. 1). Since in-that has the potential togested that their disclo-

    condence in rms. In the context of Sri Lanka, which was beset by acivil war, the destruction of civilian life and public infrastructure ledto a decrease in investor condence in rms conducting their economicactivities in that country, and reduced export income earned and for-eign investment into rms. During the civil-war period in which thisstudy was conducted, foreign portfolio investors on the ColomboStock Exchange (CSE) became net sellers, resigning their long-term out-look on the stock returns of listed rms (EIU ViewsWire, 2008; Rao,ual capital resources areiedl, 2002). The level of

    aimed at privatethat sets it apart fty is destroyed inpectations in a fuprivate-sector prlombo Stock ExcThe effect of terrogions of the cou

    rights reserved.tical instability such as war is that it weakens investor

    country beset at that time by civil wbroad view of intangibles to include aellectual capital takes a-physical asset that has

    economic activities. Browning (2005, p. C1) provided evidence thatone effect of poliby market capitalization from 1998 to 2003 in Sri Lanka, a developingar. IntCivil war, stock return, and intellectual ca

    Indra Abeysekera School of Accounting and Finance, University of Wollongong, NSW 2522, Australia

    a b s t r a c ta r t i c l e i n f o

    Keywords:Civil warEarningsIntellectual capitalSri LankaStock return

    This study examines the effeal stock return during a civStock Exchange over six yeperiod intellectual capital dlectual capital disclosure acaccounting-based earnings,turn. The ndings provide ireturn in a civil-war enviro

    1. Introduction

    This study examines the effect of intellectual capital disclosure(ICD) activity on the current stock return of the top 30 listed rmstal disclosure in Sri Lanka

    f current-period intellectual capital disclosure on earnings and current annu-ar period. Using the top 30 rms by market capitalization listed on Colombo(from 1998 to 2003), this study nds that rms do not include the current-sure in the current stock return, and the increase in the current-period intel-ty has no inuence on earnings included in the current stock return. Futuretated in the current period, by contrast are included in the current stock re-hts into the intellectual capital disclosure practice and its inuence on stocknt.

    2011 Elsevier Ltd. All rights reserved.

    uncertainty associated with intellectual capital resources can be mit-igated with greater disclosure about their future earnings potential.

    Future earnings potential from intellectual capital resources is af-fected by factors within and outside rms, and one outside factor is po-

    corporating Advances inAccountingsev ie r .com/ locate /ad iacly owned property. This is a characteristic of civil warrom a fully edgedwar: in a fully edgedwar, proper-discriminately rather than selectively. Contrary to ex-lly edged war, during the civil-war period in whichoperty remained largely intact, the listed rms on Co-hange reported increases in prots (CSE, 2000, p. 10).r activities was also felt outside the north and east re-ntry, with separatist guerrillas detonating bombs in

  • 332 I. Abeysekera / Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 331337other regions of the country to destroy government-owned propertyand human life. Such destruction heightened the uncertainty duringthe civil-war period, and was felt in the capital market with a decreasein listed rms' market capitalization due to fall in investor condencerather than due to economic activities, which in fact increased rms'prots (CSE, 2000, pp. 1027).

    During this civil-war period, the Sri Lankan government also tookseveral steps to drive its economy toward a private-sector-led,knowledge-based economy, and to heighten the role of intellectualcapital resources in rms. These steps included amendments to theCode of Intellectual Property Act 1979 (Wickremaratne, 2000), provid-ing greater protection and speedier dispute resolutions on intellectualproperty rights (BOI, 2000).

    Despite the proactive policy framework that provided increasingprotection to rms to safeguard their intellectual property, thisstudy expected to nd that investors disregarded rms current periodICD (such as intellectual property, brands, and know-how) as futureearnings news and did not include them in current stock return.This is because investors would become risk-averse during a civil-war period due to an uncertain long-term economic outlook, andwould doubt that ICD news as future earnings would be realized asactual earnings in future periods (Ashton, 2005; Brown, Lo, & Lys,1999; Lev & Zarowin, 1999; Ryan & Zarowin, 2003). Since the tangibleassets of privately held rms were not adversely affected by the civilwar conict, investors would have more certainty about future earn-ings from assets on the nancial statements being realized, if that in-formation was available as earnings forecasts. They would more likelyinclude in the current stock return future accounting-based earningsinformation provided in the current period.

    Section 2 of this article discusses prior literature. Section 3 de-scribes the Colombo Stock Market. Section 4 outlines the researchpropositions and the tests conducted. Section 5 describes the researchmethods used in data collection and Section 6 outlines the researchndings, and presents concluding remarks.

    2. Literature review

    The two approaches to conceptualizing rms' intellectual capitalare input-based and output-based. The output-based approach,which is a measurement approach, uses the difference between mar-ket value and net book value as an overall measure of rms' unac-counted intellectual capital value (Brennan, 2001; Sveiby, 1997),perceiving the difference as indicating the importance of intangibleassets over tangible assets for generating future earnings. However,the ratio between the market value and the book value indicatorhas come under criticism, as changes in accounting rules can changethe net book value, and therefore the value of rms' intellectual cap-ital. Additionally, environmental factors (such as interest rates and in-ation) can inuence the market value of a rm (Mouritsen, 1998).The input-based approach, which is process-based views intellectualcapital as comprising a collection of intangible resources that contrib-ute to rms' unique capabilities and competencies, and that are em-bedded within rms' products and services to generate highereconomic value (Mouritsen, 1998).

    In relation to the input-based approach, authors have analyzed in-tellectual capital by clustering intellectual capital resources into sev-eral categories. Sveiby (1997) collated intellectual capital resourceswith regard to how these resources are created and nurtured, whileEdvinsson and Sullivan (1996) clustered resources based on thelevel of stability. Sveiby analyzed intellectual capital resources by sep-arating them into three categories: internal structure (created andnurtured within the rm), external structure (created and nurturedwith outside relations to the rm), and employee competence (creat-ed and nurtured by renting resources from outside the rm) (pp. 1011); the contemporary literature refers to these categories as internal

    capital, external capital, and human capital (Bozzolan, Favotto, &Ricceri, 2003; Guthrie & Petty, 2000). Internal capital is the intangibleresources embedded in the corporate structure, external capital is theintangibles generated by rms through their interaction with exter-nal environment and stakeholders, and human capital is the intangi-bles generated for the rm by its staff. Edvinsson and Sullivan,however, clustered intellectual capital resources into two categories:structural capital and human capital. Structural capital is the stableaspect of intellectual capital that is bankable, and human capital isthe volatile aspect of intellectual capital, over which rms have littlecontrol. The divergence in classication among authors demonstratesthat intellectual capital could be visualized in more than one way tounderstand its contribution to rms' future earnings.

    Lundholm and Myers (2002) pointed out that discretionary dis-closure about future earnings is a response to the lost value relevanceof rms' current earnings and is generally applicable across industrysectors. As the relevance of rms' current earnings to current stockreturn decreases, Lundholm and Myers noted that there has been acorresponding increase in the relevance of rms' future earnings tocurrent stock return (Collins, Kothari, Shanken, & Sloan, 1994). TheICD as future earnings news can give rise to revisions to currentstock return, in the hope that such disclosure will lead to realized fu-ture accounting-based earnings.

    Several studies that examined the relation between rms' earn-ings and current stock return have included future earnings as a var-iable (Collins et al., 1994; Wareld &Wild, 1992). Collins et al. (1994)found that the explanatory power of the current stock return regres-sion model increased many times when future earnings was includedas a variable, instead of only current earnings. Healy, Hutton, andPalepu (1999) extended the relation between the earningscurrentstock return model by including discretionary disclosure as an addi-tional predictor of future earnings, and found that an increase in dis-closure increased the current stock return, in their earningsstockreturn regression model.

    Miller (2002) examined the relationship between discretionary dis-closure and earnings announcements, and found a positive associationbetween discretionary disclosure and current earnings. Lundholm andMyers (2002), measuring rms' disclosure activity by the ratings pub-lished in the report of the Association for Investment Management Re-search (AIMR), extended this relation by demonstrating that rms'disclosure informed future market expectations as future earnings toinvestors. The AIMR ratings, however, represented a multidimensionaldiscretionary disclosure construct (that included intellectual capital,environmental accountability, and several other disclosures), whichmight have reduced the validity of conclusions about each specictype of disclosure activity.

    Several authors have pointed out that the relation between earn-ings and the current stock return are inuenced by the industrymembership, since the length of the product cycle differs among in-dustry sectors (Lundholm & Myers, 2002; Wareld & Wild, 1992).The relationship between the current earnings and the current stockreturn becomes greater with a shorter operating cycle as there is agreater chance of earnings becoming realized in the current reportingperiod. The future earnings of rms with product cycles longer thanone year are more informative than current earnings in the currentstock return, as current period activities would lead to fewer earningsbecoming realized in the same reporting period and more earningswould be realized in future reporting periods. Additionally, re-searchers of intellectual capital have proposed that rms with highergrowth rates can inform investors about future earning capabilities tobe included in the current stock return through greater ICD activity(Edvinsson, 1997; Jenkins, 1994, p. 1; Swinson, 1998, p. 4). An addi-tional factor, rm size, can increase rms' visibility and can inuencediscretionary disclosure activity comprising future earnings news,and therefore can have a bearing on the amount of future earnings in-formation included in the current stock return (Ballas & Hevas, 2005;

    Walker, 2005).

  • earnings and the current stock return during a politically unstable en-

    333I. Abeysekera / Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 331337Much of the research on discretionary disclosure news as futureearnings has investigated rms in industrialized countries function-ing in stable political environments. Lev (2004) found that disclosingintangible investments not recognized on nancial statements helpedinvestors to make better investment decisions and more accurate val-uations of rms. Case-study research conducted by Holland (2003)revealed that a rm's central role in ICD was to inform investorsabout the rm's future earnings-generating capabilities, and an opin-ion survey conducted with CPAs conrmed that ICD informed futureearnings, and that such disclosure in the current period should leadto increase in rms' current stock return (Petty, Ricceri, & Guthrie,2008). These assertions and ndings, however, emanated from rmsoperating in stable political settings. The present study, by contrast,aims to deepen the understanding of investor behavior in relationto r...