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CHAPTER 2
THEORITICAL FOUNDATION: LITERATURE REVIEW
2.1 Financial Statements
According to Wild, Subramanyam & Halsey (2007), financial statements are the
major source of information used by its users to have an understanding about a
company. There are five components of financial statements that are available to the
users, which are balance sheet, income statement, owner’s equity statement, cash
flow statement and notes to financial statements. The preparation of financial
statements is required to provide information to its users regarding the financial
condition, performance and future prospects of a company (Alfredson, Leo, Picker,
Pacter, and Radford, 2005).
Alfredson et al., (2005) identify that each financial statement has its own objectives.
Balance sheet is prepared to provide information about a company’s financial
condition, while income statement is used to provide information about a company’s
financial performances. The owner’s equity statement is used to assess the full
performance of a company, it includes revenues, expenses, gains or losses that are
reported in income statement and also transactions related to equity holders (such as,
owner’s investments and withdrawal). Moreover, the statement of owner’s equity
acts as a connection between the balance sheet and income statement. Cash flow
statement is prepared to support users with the information about the movement of
cash (inflows and outflows) in the company. The last statement which is the notes to
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financial statements contains additional information to improve the understanding of
the other four statements mentioned above.
Basically, the objective of financial statements is to provide useful information to its
users. However, the preparation of financial statements that contains useful
information requires the preparers to understand the conceptual framework of
financial reporting. The framework prepared by accounting standard boards will act
as a guidance to identify the restrictions of financial reporting, identify the events
that are required to be reported, the methods to recognize and measure those events
and the procedures to summarize and report the events (FASB, 2006).
2.2 Conceptual Framework for Financial Reporting
The Financial Accounting Standards Board (FASB, 2006) determines the conceptual
framework for reporting financial statements, which defines the objective of
financial reporting, qualitative characteristics of accounting information, elements of
financial statements, and the operating guidelines of financial statements. The
conceptual framework prepared by FASB can be divided into three different levels
consisting of (Kieso, Weygandt and Warfield, 2004):
• Level 1: Objectives of financial reporting – The “why” – Goals and Purposes of
accounting
• Level 2: The bridge between level 1 and level 3 – consists of the qualitative
characteristics of accounting information and the elements of financial
statements
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• Level 3: Operating guidelines (Recognition and Measurement Concepts) - The
“how” implementation
The three different levels can be illustrated into a diagram that is prepared by Kieso
et al., (2004).
Source: Kieso, Weygandt and Warfield (2004), p.30
Figure 2.1
Conceptual Frameworks for Financial Reporting
FASB (2006) identifies that the objectives of financial reporting are to provide
useful information for investing and financing decisions, for assessing future cash
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flows, and report information regarding the company’s resources, claims on the
resources and the changes in resources and claims. Besides FASB, the Indonesian
Institute of Accountants (IAI) also publishes an accounting standard called “Standar
Akutansi Keuangan” (IAI, 2007) that determines similar financial reporting’s
objectives.
In order to provide useful information, FASB (2006) and IAI (2007) require
accounting information to possess qualitative characteristics which are relevance,
reliability, comparability and consistency. FASB (2006), IAI (2007), Weygandt,
Kieso and Kimmel (2005), Stice, Stice and Skousen (2000) and Alfredson et al.,
(2005) describe each of the qualitative characteristics of accounting information as
follows; accounting information is relevant when it is able to influence the decision
of its users (relevant), it is reliable if it is free from material error and bias
(reliability), it should be comparable with other entity or comparable accounting
information over time within the entity itself (comparability), and financial
statements are prepared using the same accounting principles over time
(consistency).
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Source: Kieso, Weygandt and Warfield (2004), p.32
Figure 2.2
Hierarchy of Accounting Qualities
Figure 2.2 shows the relationship of the accounting qualities defined by Financial
Accounting Standard Board. It shows that accounting information needs to be
understandable, and useful for decision making.
The four qualitative characteristics are further classified by FASB, Statement of
Financial Accounting Concepts No. 2 (2008) into two groups, which are primary
qualities and secondary qualities. The primary qualities consist of relevance and
reliability, while the secondary qualities consist of comparability and consistency. It
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can be seen from the figure that each primary quality can be described by three
different components.
FASB (2008), Weygandt et al., (2005), Stice et al., (2000) and Alfredson et al.,
(2005) identify that the components of relevance in accounting information are
feedback value, predictive value and timeliness. Feedback value allows information
to be useful for the confirmation and correction of past expectations. Predictive value
allows accounting information to forecast the outcome of similar future events.
Timeliness means that information is always updated and available whenever the
users need to make their decisions.
Besides that, they also identify the components of reliability, which are verifiability,
faithful representation, and neutral. Verifiability requires the information to be
prepared under a method that can be verified by other accountants using the same
method. Faithful representation requires information to present the facts of an event
or transaction. Neutral means that the information is not made to support one
particular party over another and it does not have the intention to influence any users
to make a particular decision that is in favor of its preparers.
Stice et al., (2000) argue that the main purpose of financial reporting is to provide
valuable information to its user decision making process. Despite of all the
qualitative characteristics of accounting information that have been described above,
this paper focuses only on the relevance of accounting information which aims to
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identify whether accounting information provided in financial statements are able to
influence its users on their pricing decisions.
2.3 The Value Relevance of Accounting Information
Accounting information will be considered as relevant if it is able to influence the
decision of its users. Wild et al., (2007) suggest that value relevance of accounting
information can be observed by examining the explanatory power of accounting
information provided in financial statements, to reveal share prices. Francis and
Schipper (1999) point out four possible interpretations of value relevance in their
studies and one of the interpretations is similar to the suggestion given by Wild et
al., (2007). They state that:
‘A statistical association between accounting information and market value of
returns, particularly over a long window, might mean only that the accounting
information in question is correlated with information used by investors
(Interpretation 4). Under this view, value relevance is measured by the ability of
financial statement information to capture or summarize information, regardless
of source, that affects share values.’
Besides of these studies, many other researchers have used the same interpretation to
test the value relevance of accounting information. Therefore, this paper will
perform an analysis on the relationship of accounting information and share prices,
to determine the value relevance of accounting information.
It is known that various researches on the value relevance of accounting information
had been done by researchers around the world. They had used different accounting
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variables as the proxies of accounting information, such as earnings, residual
income, dividends and book value. However, it is identified that earnings and book
value have been the most common variables that are used to represent accounting
information (Collins et al., (1997), Lev & Zarowin (1999), Francis and Schipper
(1999)).
2.3.1 The Value Relevance of Earnings
In financial statements, earnings are usually known as net income, it is the bottom
line of income statement. Earnings allow the users of financial statements to know
about a company’s performance. According to Wild et al., (2007), earnings are more
relevant compared to cash flow due to the reason that it can predict future income
and measure the financial condition and performance of a company.
Ball & Brown (1968), Easton & Harris (1991) and Ohlson & Shroff (1992) identify
that there is a relationship between earnings and share price. These findings help to
discover that earnings can be the explanatory power of share prices. Many studies
had been done to determine the value relevance of earnings. Bowen, Burgstahler and
Daley (1987), Abukari, Jog and McConomy (2000), and Easton, Harris & Ohslon
(1992) have the same findings that earnings are one of the variables that explains
share price. Pradhono and Christiawan (2004) conduct a research involving
manufacturing firms that are listed in Indonesia Stock Exchange (IDX). They
discover that earnings have a significant relationship with share prices.
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Many studies conducted in different countries were able to identify that the value
relevance of earnings has been increasing over time. Hutagaol and Pranatio (2009)
conduct a research using LQ 45 companies that were listed in IDX during 2003 to
2007. They found that value relevance of earnings have been increasing over time.
Kadri, Ibrahim and Aziz (2009) also identify that there is an increasing trend on the
explanatory power of earnings. They used high technology firms as their sample
because previous research performed by Dontoh, Radhakrishnan and Ronen (2004),
and Liang and Yao (2005) suggest that those firms are the industries that are most
affected by the decline in the value relevance of accounting information. Gjerde,
Knivsflå* and Sættem (2009) perform a research to test the value relevance of
financial reporting in Norway during 1965 to 2004 and they also discover that the
value relevance of earnings have been increasing over time.
In contrast to the studies performed above, there are also empirical studies that show
the decline in the explanatory power of earnings. Davis-Friday and Gordon (2002)
conduct a study using Mexican firms during the period 1992 to 1997 and find that
the explanatory power of earnings decline due to the presence of negative earnings.
Broedel Lopes (2002) signifies that earnings do not provide relevant information for
the equity valuation in Brazil.
Rahmawati (2005) had performed a research by collecting the financial statements of
41 listed manufacturing firms in IDX. The result of her research determines that
earnings had lost its value relevance during 1998 to 2002. Research performed by
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Collins et al., (1997), Barth, Beaver and Landsman (2001) and Lev and Zarowin
(1999) indicate that there is a significant decrease in the value relevance of earnings
over time.
2.3.2 The Value Relevance of Book Value
According to Spremann and Gantenbein (2002), book value of equity has been
included as one of the variables that may explain share price, due to the framework
created by Feltham-Ohlson (1995). The Feltham Ohlson framework define share
price as a function of earnings and book value of equity. Spremann and Gantenbein
(2002), Collins, Pincus and Xie (1999) also state that book value of equity represents
the net assets used to generate normal earnings that are expected to persist in the
future. Several studies performed by Abukari et al., (2000), Broedel Lopes (2002),
Hutagaol and Pranatio (2009) and Burgstahler and Dichev (1997) have also specified
that book value should be included as one of the explanatory variable of share prices.
Some studies discover that the value relevance of book value has been declining over
time. Kadri et al., (2009) show that there is a downtrend in the value relevance of
book value over time. Lev and Zarowin (1999) also document that the relationship
between book value and capital market values has weakened due to the change in
business environment and the inadequacy of the change in accounting treatment.
In contrast to studies performed by Kadri et al., (2009) and Lev and Zarowin (1999),
other studies performed by Suwardi (2005), Francis and Schipper (1999) and Collins
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et al., (1997) discover that the value relevance of book value increases over time.
Collins et al., (1997) explain that the increase in the value relevance of book value
may be influenced by several factors such as the increase in non-recurring items,
firm size, negative earnings and intangible firms.
Many study such as Collins et al., (1997), Spremann and Gantenbein (2002),
Subramanyam and Venkatachalam (2000) state that book value can be used as a
proxy to forecast future earnings when transitory components are material in current
earnings. Besides that, it is also useful because it acts as a proxy for the liquidation
or abandonment option for firms with poor performance. With the support of these
studies, Collins et al., (1999) find that the omission of book value from the simple
earnings capitalization model creates a negative (positive) bias in the coefficient of
earnings for loss (profit) firms. Therefore, book value is said to be able to contribute
in the elimination of the negative relation between price and return found in loss
firms. However, research performed in Greece by Papadaki and Siougle (2007),
discover that the inclusion of book value in the simple earnings capitalization model
does not assist in eliminating the negative coefficient on earnings of loss firms.
2.3.3 The Value Relevance of Cash Flow
In addition to earnings and book value, many studies have also included cash flow to
determine share prices. Sumarni and Rahmawati (2007), Bowen et al, (1987),
Pradhono and Christiawan (2004) discover that cash flow contains information to
explain share prices.
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According to Keown, Martin, Petty and Scott (2005), cash flows are important
compared to profits because it is cash that is actually received and reinvested by
firms. Cash flows are also the important components used in capital budgeting. It can
be used to project the Net Present Value (NPV) of an investment and the NPV will
be used to make investment decision. Keown et al., (2005) and Berk, Demarzo and
Harford (2008) indicate that Free Cash Flow (FCF) Valuation Model can be used to
value a firm. Firm value can be found using the FCF model by dividing the total
present value of all future free cash flows to the company’s weighted average cost of
capital. Through this model (given in Figure 2.3), share value can be determined.
Source: Keown et al, (2005), p.440 & 443
Figure 2.3
Free Cash Flow Valuation Model
FCF Valuation Model is one of the examples to indicate that there is a relationship
between cash flows and share price.
Darwin (2008) conducts a research in Indonesia and observes that there is no
significant evidence to conclude that cash flows are related to share prices during
1992 to 1995. Nevertheless, she observes that there is a significant relationship
between cash flow and share price during 1996 to 2005. She predicts that cash flow
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statements of Indonesian companies were still ineffective during 1992 to 1995 and
caused cash flows to have an insignificant relationship with share prices during that
period.
Juniarti and Limanjaya (2005) conduct a research involving 50 Indonesia’s listed
companies and find that cash flow is more relevant than earnings for companies that
are in the growth and mature stage. Lev and Zarowin (1999) state that cash flow is
more informative than earnings as the probability of manipulating cash flow is lower
than earnings. However, they do not find the evidence that the value relevance of
cash flow increases over time. Cash flow is also determined to have higher
explanatory power in equity valuation when earnings are transitory (Charitou, Clubb
and Andreou (2000), Cheng, Liu and Schaefer (1996) and Habib (2008)).
On the other hand, Habib (2008) finds that the explanatory power of earnings is
higher than cash flow; however the difference appears to be insignificant.
Thinggaard and Damkier (2008) also show that investments decisions that are made
based on accrual information are more profitable than the investment decisions that
are made based on cash flow information. This means that accrual information
(earnings) is more relevant than cash flow. FASB (2006) clarifies in ‘Conceptual
Framework for Financial Reporting’ that:
‘The accrual accounting information in financial reports about an entity’s
resources and claims and changes in resources and claims generally provides a
better basis for assessing cash flow prospects than information solely about the
entity’s current cash receipts and payments. Without accrual accounting,
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important economic resources and claims to resources would be excluded from
financial statements.’
These statements highlight the importance of variables prepared by using accrual
method over cash flow variables.
2.3.4 Prior Research on the Trend of the Value Relevance of Accounting Information
The value relevance of accounting information can be tested by examining whether
the information published in financial statements is useful to influence user’s
decisions. Financial statements provide much information that can be used as a
proxy for accounting information. However, many prior researches have used
earnings, book value or cash flow to represent accounting information.
Many studies have confirmed that combining several variables into one model can
provide higher explanatory power for share prices. Bae & Kim (1998) suggest that
book value (earnings) can explain some factors of share prices that are not explained
by earnings (book value). They also find that both book value and earnings have
value relevance towards share prices and both are complementary to each other.
Bowen et al, (1987), Charitou et al., (2000), Habib (2008) identify that cash flow
(earnings) have incremental information content beyond earnings (cash flow) in
explaining security returns, which signifies that combining both cash flow and
earnings will provide higher explanatory power for security returns.
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Studies have been made to discover the trend in the value relevance of accounting
information over time. Graham and King (1998) show mixed results in determining
the value relevance of accounting information for different countries over time. They
identify that the value relevance of accounting information in Korea, Philippines and
Taiwan increases over time, while Indonesia and Thailand experience a decline in
the value relevance of its accounting information.
Eng, Li and Mak (1999) identify that Australia, France and Germany has an
increasing trend in the value relevance of accounting information, whereas United
States of America, Japan and Sweden show an opposite trend. Davis-Friday and
Gordon (2002) perform a study in Mexico and identify that the value relevance of
Mexican accounting information does not show a decline during the economic crisis.
With the support of their findings, they state that the accounting system in Mexico
can be used to improve the financial reporting in United States.
Dontoh et al., (2004) find that the R² of the model used in the research has decline
over time which means that the explanatory power of accounting information falls
and it was affected by the increasing amount of Non-Information Based trading.
Cortijo, Palmon and Yezegel, Core, Guay and Buskirk (2001), Lev and Zarowin
(1999) indicate that there is a decline in the usefulness of accounting information due
to the change in business environment (from low-tech to high-tech firms). Gu (2007)
and Brown, Lo and Lys, (2000) find that there is a decline in value relevance when
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alternative measure such as regression residual dispersion are used to measure value
relevance.
In the contrary to the research pointed above, Thinggaard and Damkier (2008) note
that the result of their research indicates that the value relevance of accounting
information in Denmark remained unchanged over time (1983-2001). Moreover,
several numbers of studies (Landsman and Maydew (2002), Gjerde et al., (2009) and
Kadri et al., (2009)) had found that the value relevance of accounting information
does not decline over time. Collins et al., (1997), Francis and Schipper (1999), Ely
and Waymire (1998) observe that there is an uptrend in the value relevance of
accounting information during the mid of 1950s to the early of 1990s.
As stated before, Graham and King (1998) find that the usefulness of Indonesian
accounting information falls. In contrast to their study, Hariani and Nashih (2006),
Hutagaol and Pranatio (2009), and Darwin (2008) find an uptrend in the value
relevance of Indonesian accounting information. The inconsistency of their findings
may be due to the difference in the period in which they conduct the research.
Graham and King (1998) use 338 firm years in Indonesia to conduct the research and
the data is taken from the year 1991 to 1995. Financial firms and firms with negative
book values are removed from the sample collections in their research. Hariani and
Nashih (2006) also conduct their research in Indonesia, but they obtain their data
from the year 1993 to 2003. Besides that, they exclude new firms and firms with
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negative earnings from their samples. Hutagaol and Pranatio (2009) perform a
research to identify the change in the value relevance of accounting information by
using samples from LQ 45 firms in Indonesia. Their samples are collected based on
the list of LQ 45 at the end of December 2002. The data are obtained from the period
of 2003 to 2007 and 220 firm years are used as their final samples.
Darwin (2008) performs a research in Indonesia by including data from 1992 to 2005
and obtains a final sample of 1151 firm years. She excludes financial firms and firms
that report their financial statements in currencies other than Rupiah. The research
performed by Darwin (2008) involves using the same number of firms each year; it
includes 86 firms that are listed every year during 1992 to 2005. As the research is
conducted using the data from 1992 to 2005, the author decides to divide the sample
into two periods which are the pre-crisis and post-crisis period. This is done to
prevent distortions in the research that can be caused by the change in the financial
condition and structural change in Indonesia.
2.3.5 Factors Affecting the Value Relevance of Accounting Information
Collins et al., (1997) classify that there are four factors that may affect the value
relevance of accounting information. The four factors are the increase in the number
of intangible firms, increase in non-recurring items, the presence of negative
earnings and difference in firm sizes.
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Cortijo et al., (1997) find that the accounting information provided by high-
technological firms (contain higher intangibles) are less relevant compared to low-
technological firms. Lev and Zarowin (1999) also conduct a research to test the
impacts of intangible firms on the value relevance of earnings information. They find
that increasing intangible investment, such as research and development (R&D) can
cause a decline in the earnings’ explanatory power. Core et al., (2001) show that
using subsamples that include high-technological firms have caused the explanatory
power of accounting information to decline over time. On the contrary, Kadri et al.,
(2009) and Broedel Lopes (2002) state that intangible firms do not cause a decline in
the explanatory power of accounting information. Francis and Schipper (1999) also
find that high-technological firms do not show higher decline in value relevance of
accounting information compared to low-technological firms.
Davis-Friday and Gordon (2002) and Barth et al., (2001) identify that the decline in
the explanatory power of earnings are caused by the presence of negative earnings.
Research conducted by Hutagaol and Pranatio (2009) fail to discover that there is an
impact of negative earnings on equity valuation. They predict that the use of a small
number of samples containing negative earnings may be the reason of the
unexpected findings. Filip and Raffournier (2010) conclude that the relationship
between earnings and market return increase significantly when they exclude
negative earnings, this means that the presence of negative earnings decrease the
relationship between earnings and market return.
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According to Collins et al., (1997), non-recurring items are also considered as
transitory components. Brown and Sivakumar (2003), Elliot and Hanna (1996),
Elliot and Shaw (1988) and Ali and Zarowin (1992) conclude that accounting
information that contain less transitory components or non-recurring items are more
relevant than information with more transitory components.
Firm size can be identified by determining the life cycle stage of a company. Collins
et al., (1997) point out that startup companies may be considered as smaller firms
that are likely to report losses. They expect that book values will be more relevant
for smaller firms. Hayn (1995) find that information content of earnings increase
with the reduction in the frequency of losses. As smaller firms are predicted to report
losses more frequently than larger firms, it can be regarded that the information
content of earnings for smaller firms are lower than larger firms.
2.4 Methodology for Value Relevance Analysis
Value relevance can be tested by identifying how accounting information can reveal
share prices. However, the measurement of how well accounting information can
reflect share prices require the use of statistical tools. Different methods have been
used to measure value relevance, such as Coefficients of Determination (R-Squared
or R²), R-squared after controlling for scale effects and the regression residual
dispersion.
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R-Squared method is used frequently by many researchers to measure value
relevance (Brown et al., (2000)). Researchers such as Collins et al., (1997), Francis
and Schipper (1999), Hariani and Nashih (2006), Hutagaol and Pranatio (2009),
Kadri et al., (2009), Suwardi (2005) and Ely and Waymire (1998) employ the R-
Squared method to investigate whether accounting information is relevant and
whether it has changed over time. According to Brown et al., (2000), ‘R-Squared is a
measure of the explanatory power of the independent variables in a linear
regression’. R-Squared is also known as the coefficient of determination; it explains
the degree of dependent variables that can be explained by independent variables
(Keller, 2005). In this study, the independent variables will be the variables that have
been chosen to represent accounting information, while the dependent variable will
be the share price.
Although R-Squared method is commonly used by researchers, studies have been
done to prove that the R-Squared method is unreliable. Brown et al., (2000), Gu
(2007), Chang (1999) and Cortijo et al., suggest that R-squared method are not a
reliable statistic due to the exposures to scale factor and heteroscedasticity in
regression variables. They suggest some approaches or techniques to control the
exposures that are faced by R-Squared method.
Brown et al., (2000) are concerned regarding the bias that may be caused by using
the Coefficients of Determination (R²) in price levels regression. They believe that
R-Squared method is exposed to scale effects because different samples may have
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different scaling factor. They identify that there is a positive relationship between R²
and the coefficient of variation (CV) of the scale factor, therefore, even when the
value relevance remains unchanged, R² will be higher due to the increase in the CV
of the scale factor. In response to the concern mentioned by Brown et al., (2000)
regarding the different scaling factors that exist in different samples, this study have
dealt with this issue by conducting an extended research that performs a quartile
analysis on the research samples.
Two approaches are suggested by Brown et al., (2000) to control the scale effects in
R², which are an empirical analysis between R² and scale effects, and an analysis
from deflated regressions. Empirical analysis between R² and scale effects involves
the investigation of whether an increase in CV can affect the increase in R² and how
it correlates with time. After the findings are obtained, the trend in the R² of
accounting information after controlling for changes in the CV of the scale factor
will be investigated. The next approach which is the analysis from deflated
regressions involves the deflation of the variables by a scale proxy (a proxy for
unobservable scale factor). By ignoring the scale effects, the R² of the model will be
upwardly biased. The amount of the bias depends on the CV of the scale factor. This
study has also control the scale effects in R² by deflating the research model using a
size proxy which is the number of outstanding shares.
Gu (2007) has proposed the use of the regression residual dispersion for determining
the value relevance of accounting information. He believes that the use of R-squared
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method to explain the value relevance of accounting information is incomparable
across samples. Gu (2007) interpret residual dispersion as the pricing errors that are
not captured by accounting information. However, even though regression residual
dispersion is exposed to nonlinear scale effects that are related to the magnitude of
price/ return levels, Gu (2007) suggests some techniques to control the effects. The
techniques are to measure scale-adjusted abnormal pricing errors (also called as size-
adjusted abnormal returns), examine time patterns of the pricing errors within the
deciles where scales have already been aligned, and find scale-matched samples.
This study does not apply the method that has been proposed by Gu (2007).
However, the author would like to recommend the use of the regression residual
dispersion method in future research. This is to identify whether the method
proposed by Gu (2007) will affect the results obtained from the R-Squared method.
Recommended