Accounting Research Center, Booth School of Business, University of Chicago

Country-Specific Factors Related to Financial Reporting and the Value Relevance of Accounting
Data
Author(s): Ashiq Ali and Lee-Seok Hwang
Source: Journal of Accounting Research, Vol. 38, No. 1 (Spring, 2000), pp. 1-21
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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Journal of Accounting Research
Vol. 38 No. 1 Spring 2000
Printed in US.A.

Country-Specific Factors
Related to Financial Reporting
and the Value Relevance of
Accounting Data
ASHIQ ALI* AND LEE-SEOK HWANGt

1. Introduction
Using 1986-95 data from manufacturing firms from 16 countries, this
paper explores relations between measures of the value relevance of fi-
nancial accounting data and several country-specific factors suggested
in prior research. Value relevance is specified primarily in terms of
explanatory power of accounting variables (earnings and book value of
equity) for security returns, relative to explanatory power for compara-
ble U.S. firms. Five country-specific factors are considered.
First, we find that value relevance is lower for countries with bank-
oriented (as opposed to market-oriented) financial systems. In bank-
oriented financial systems a few banks supply most of the capital needs

*University of Arizona; tBaruch College, City University of New York. We gratefully

acknowledge the comments of Andrew Alford, Bill Baber, Sudipta Basu, Fred Choi, Lil
Mills, Gary Mueller, two anonymous referees, and participants in workshops at the Uni-
versity of Arizona, Baruch College, the 1996 National Meeting of the American Account-
ing Association, the 1997 International Conference on Operations and Quantitative
Management, the 1997 KPMG/AAA International Accounting Research Conference, and
the 1997 Conference on International Accounting Related Issues at Rutgers University.
An earlier version of the paper was circulated with the title "The Level of Alignment of
Financial and Tax Accounting and the Value Relevance of Financial Accounting Data: Ev-
idence from Cross-Country Comparison." Ashiq Ali acknowledges financial support pro-
vided by Ernst and Young and the Eller College of Business and Public Administration.

i
Copyright?, Instituteof ProfessionalAccounting,2000

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2 JOURNAL OF ACCOUNTING RESEARCH, SPRING 2000

of businesses (Berglof [1990]), whereas in market-oriented financial sys-

tems numerous diverse investors provide financing. Our finding is con-
sistent with lower demand for published value-relevant financial reports
in bank-oriented systems, because in such systems, banks have direct
access to company information (see, e.g., Mueller, Gernon, and Meek
[1994], hereafter MGM).
Second, we find that value relevance is lower for countries where pri-
vate-sector bodies are not involved in the standard-setting process. This
finding is consistent with the premise that government standard setters
establish financial accounting rules whose primary purpose is to satisfy
regulatory needs such as computing income taxes or demonstrating com-
pliance with the national government policies and macroeconomic plans
(Choi and Mueller [1992]).
Third, consistent with arguments made by MGM,we find that value rel-
evance is lower for Continental model countries than for British-Amer-
ican model countries. Fourth, we find that value relevance is lower when
tax rules significantly influence financial accounting measurements. This
finding is consistent with tax laws being influenced by political, social,
and economic objectives rather than the information needs of investors.
Furthermore, requiring tax-financial reporting conformity provides in-
centives to reduce taxes by reporting systematically lower profits, thereby
undermining the value relevance of financial reports (Choi and Mueller
[1992] and Joos and Lang [1994]). Finally, we find that value relevance
is higher when more is spent on external auditing services. This finding
suggests that resources committed to auditing indicate the importance
or the extent of demand for financial accounting (MGM).
Prior studies (see, e.g., MGM) consider bank- versus market-oriented
financial systems and government versus private standard setters as envi-
ronmental factors that influence accounting development. On the other
hand, they consider British-American versus Continental accounting
clusters, financial-tax alignment, and spending on auditing services as
factors distinguishing national financial reporting practices. We find
that the five factors we consider are strongly interrelated. Principal fac-
tor analysis shows that only one underlying construct manifests itself in
the country-specific factors we consider. We are not, however, able to
label the construct.
Alford, Jones, Leftwich, and Zmijewski [1993] (hereafter AJLZ) report
the value relevance of financial accounting data for the same 16 coun-
tries we consider. We contribute by examining in detail the association
between value relevance and country-specific factors related to financial
reporting. We consider both AJLZ's measures of the value relevance of
earnings and two other measures. First, because jurisdiction-specific ac-
counting practices influence accruals more than cash flows, we consider
the value relevance of accruals alone. Second, because accounting rules
in bank-oriented countries tend to emphasize valuing balance sheet

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 3

items (Joos and Lang [1994] and Gray, Campbell, and Shaw [1984]), we
consider the combined value relevance of earnings and book value of
equity.
We note that the association between accounting numbers and stock
market metrics, such as returns, is affected by intercountry differences in
the extent to which information in financial reports is reflected in lead-
ing-period returns as compared to contemporaneous returns (Kothari
and Sloan [1992] and Jacobson and Aaker [1993]). We show that this
effect, which we refer to as the price leading financial reports effect,
differs significantly between bank- and market-oriented countries. Ignor-
ing this effect induces spurious association between value relevance mea-
sures and financial system characteristics. We show that our conclusions
about the relations between value relevance and country-specific factors
are robust to using value relevance measures that are adjusted for this
confounding effect.
Our results on the relations between country-specific factors and
value relevance are pertinent to the debate on international standard-
ization of accounting practices. For example, the basis of the Interna-
tional Accounting Standards Committee (IASC) conceptual framework
is the value relevance of financial reports (Choi et al. [1992]). However,
it is not clear that value relevance of financial reports is accepted in all
jurisdictions as the primary consideration in financial reporting stan-
dard setting. We show that countries with low demand for information
from published financial reports tend to employ accounting practices
that produce accounting data with low value relevance. Such countries
might be reluctant to adopt accounting practices that emphasize value
relevance. In fact, the IASC is criticized by some of these countries for
its conceptual framework (Choi et al. [1992]).
Section 2 discusses the relations between country-specific factors and
value relevance, and presents measures of country-specific factors. Sec-
tion 3 describes the measurement of accounting variables and the sam-
ple. Section 4 discusses the value relevance measures. Section 5 presents
the results of the relations between value relevance and country-specific
factors. Section 6 discusses the sensitivity of the results to the price lead-
ing financial reports effect. Section 7 concludes the study.

2. Country-Specific Factors Related to Financial Reporting and

Value Relevance

2.1 DISCUSSION OF COUNTRY-SPECIFIC FACTORS

Berglof [1990] suggests two types of financial systems-bank-oriented

and market-oriented. In bank-oriented systems, businesses generally have
very close ties to their banks, which supply most of their capital needs;
banks have concentrated and long-term debt and equity holdings; and

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4 ASHIQ ALI AND LEE-SEOK HWANG

banks have direct access to company information, reducing the demand

for published financial statements. Market-oriented systems, on the other
hand, contain numerous diverse investors without direct access to com-
pany information. Investors are likely to rely heavily on financial account-
ing disclosures to obtain information to be used in security valuation
and monitoring management. Therefore, market-oriented systems are
expected to exhibit greater value relevance of financial accounting dis-
closures.1 We use two measures to capture the degree of bank or market
orientation.
The first measure is the debt-to-asset ratio. Berglof [1990] notes that
the absence of strong restrictions on commercial banks in bank-oriented
systems means banks can more effectively control firms and, thus, ex-
tend credit beyond levels typically observed in market-oriented financial
systems. Consistent with this argument, he shows that bank-oriented sys-
tems have higher debt-to-asset ratios. Because debt-to-asset ratios can
also be affected by year, industry, and firm size, we use matched U.S.
sample firms to control for these three factors. Specifically, we measure
the Debt-AssetRatio as the difference between the median debt-asset ra-
tio of a country and the median debt-asset ratio of 100 U.S. samples
matched by year, industry, and firm size.
The second measure is the number of publicly traded domestic firms
in a country relative to its population (in millions). La Porta et al.
[1997] suggest that this measure captures the extent of the market
breadth of equity finance. Since the concentration of equity and debt
holdings for a country are positively correlated (Berglof [1990]), this
measure would also capture the breadth of debt finance. Thus, we use
this measure as a proxy for the degree to which a country's financial sys-
tem is market oriented. The DomesticFirms-to-PopulationRatio for 1994
is taken from La Porta et al. [1997].
If financial accounting rules are set by government bodies, the ten-
dency is to set rules that satisfy government needs, such as computing
income taxes or demonstrating compliance with national government
policies and macroeconomic plans (Choi and Mueller [1992]). Where
accounting practices are determined primarily by accountants, the ob-
jective is more likely to be the integration of emerging accounting ideas
into the existing structure of standards (Wyatt [1997]). In such regimes,
regulatory requirements are less likely to determine financial accounting

'Alternatively, more value-relevant financial reporting reduces moral hazard problems

facing individual investors, making widespread public ownership of securities possible and
thereby affecting the financial system of the country (Saudagaran and Biddle [1992]). It is
also possible that both the type of financial system and the reporting practices are endog-
enous to something else. We do not posit causation but merely examine the association
between country-specific factors and value relevance.

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 5

practices, and accounting is more likely to address the needs of capital

providers (Choi and Mueller [1992]). We therefore expect that financial
reports in countries with private-sector standard-setting bodies are more
value relevant. Using data from AJLZ, we code our sample according
to whether generally accepted accounting principles (GAAP) are deter-
mined solely by the government (0) or whether the private sector also
participates (1). We call this variable Sourcesof GAAP2
Prior studies examine countries' accounting practices according to the
overall similarities in their practices (see, e.g., Frank [1979], Nair and
Frank [1980], Nobes [1983], and Salter and Doupnik [1992]).3 MGM
aggregate the findings of prior research to classify countries into four
accounting clusters: British-American, Continental, South American, and
Mixed Economy. Our sample countries fall in either the British-Ameri-
can or the Continental model cluster. MGM also note that British-Ameri-
can model accounting practices are oriented toward the decision-making
needs of investors and creditors and, therefore, the accounting data are
likely to be more value relevant. We code the Continental model coun-
tries as 0 and British-American model countries as 1 and refer to the
variables as the Accounting Cluster.
The Accounting Clustervariable aggregates differences in accounting
measurement practices across countries. Since tax rules can be especially
influential on financial accounting measurement (see, e.g., AJLZ), we
examine tax effects separately.4 In some countries, financial reports ef-
fectively reflect tax laws, which are in turn influenced by political, eco-
nomic, and social objectives, such as promoting or discouraging certain
types of economic activities, promoting employment, controlling infla-
tion, or redistributing wealth. Because the primary objective of tax rules
is not to satisfy the information needs of capital market participants, the

2 MGM note that the literature identifies five environmental factors that influence ac-
counting development in a country. We do not examine the factor "political and economic
ties" because of difficulty in developing an objective and meaningful measure (Doupnik
and Salter [1995]). We also do not examine level of inflation or size and complexity of busi-
ness enterprises, because our sample consists only of developed countries, which limits vari-
ation in these factors.
'For example, Salter and Doupnik [1992] survey accounting practices for 50 countries.
Survey participants were auditors with significant auditing experience in the subject coun-
try (mean experience of 17 years). The survey contained 100 financial reporting practices
(55 disclosures and 45 measurement items). The participants were asked to indicate for
the country of their expertise the percentage of economically significant entities following
specific accounting practices. The data were then used to identify clusters of countries
with similar accounting practices.
4Other dimensions identified in the literature along which accounting measurement
practices differ across countries include conservatism/prudence, strictness of application
of historic cost, susceptibility to replacement cost adjustments in main or supplementary
accounts, consolidation practices, flexibility with respect to provisions to smooth income,
and uniformity in the application of rules (see Nobes [1983]).

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6 ASHIQ ALI AND LEE-SEOK HWANG

value relevance of financial reports in countries with high tax-book con-

formity is compromised. Furthermore, required conformity between
financial and tax reporting provides incentives to reduce taxes by re-
porting systematically lower profits, and this too undermines the value
relevance of financial reports (Choi and Mueller [1992] and Joos and
Lang [1994]). We use AJLZ's data to code our sample as high (0) versus
low (1) alignment of financial and tax accounting. We refer to this vari-
able as Financial-Tax Alignment.
We use the level of spending on external auditing services to indicate
the importance or the extent of demand for financial accounting (MGM).
As the value (or importance) of financial accounting increases, so too
should the value relevance of financial reports. For 14 of our 16 sample
countries, MGM report total fees of the country's ten largest accounting
firms as a percentage of the country's gross domestic product for 1990.5
We refer to this variable as Spending on Auditing Services.6

2.2 CORRELATIONS AMONG THE COUNTRY-SPECIFIC FACTORS

Country characteristics are expected to be correlated. For example,

MGM note that Continental accounting model countries generally have
bank-oriented financial systems. Relatedly, Frost and Ramin [1996] note
that bank-oriented countries have less demand for independent audits
and for a sophisticated investor-oriented financial reporting system and,
therefore, spending on external auditing services is likely to be low.
Table 1 summarizes variables that represent country-specific factors
for the 16 sample countries. Table 2 reports Spearman correlations be-
tween the variables. As expected, the two measures of financial systems,
Debt-Asset Ratio and Domestic Firms-to-Population Ratio, are strongly corre-
lated (p = -0.77, p = 0.00). Most of the variables representing different
country-specific factors are strongly interrelated, with correlations ex-
ceeding 0.60 in magnitude in all but one case.
Given these high correlations, we use principal factor analysis to in-
vestigate whether the variables representing the country-specific factors

5A better measure would be the total amount spent on the preparation of financial
reports (including expenditures on internal and tax auditors), instead of just funds spent
on external auditing services. Unfortunately, these data are not available. Also, we do not
have data on total external audit fees by all accounting firms.
6Differences in the level of public disclosure of financial information across countries
is another important country-specific factor related to financial reporting (Saudagaran
and Biddle [1992], Frost and Pownall [1994], and Frost and Ramin [1997]). Higher dis-
closure levels suggest a greater demand by investors for financial data (Frost and Ramin
[1997]) and, thus, the value relevance of accounting data is expected to be greater. We do
not include this factor in our study because of limited data availability. Saudagaran and
Biddle [1992] rank 7 of our 16 sample countries on overall disclosure levels. Our analysis
of these 7 countries shows that the correlations between the level of public disclosure and
the value relevance measure we consider range from 0.35 to 0.64, with the p-values of 0.22
to 0.06. The signs of these correlations are as expected, but the significance levels are
somewhat weak, probably due to the small sample size.

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 7

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 8 ASHIQ ALI AND LEE-SEOK HWANG

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 9

capture only one underlying construct.7 We find that one principal fac-
tor captures 84.9% of the variation in the observables. Other factors are
insignificant with Eigenvalues of less than one (Hair et al. [1979]). As
expected, the first principal factor is strongly correlated with all the vari-
ables (see table 2). We make no attempt to label the underlying con-
struct and refer to it as the Principal Factor.

3. Sample and Accounting Variables Measurement

Our sample consists of firm-year observations from 16 non-U.S. coun-
tries; U.S. firms are used as controls. Countries must have at least 60
usable firm-year observations. Accounting data, stock price, and stock re-
turns for 1986-95 are from the 1995 GlobalVantagedatabase. We use the
criteria of AJLZ and focus on industrial firms (SIC 2000-3999 or 5000-
5999) in each country. GlobalVantagedistinguishes each firm-year obser-
vation according to one of 12 accounting standards (domestic standard,
modified U.S. standard, etc.) and one of four levels of consolidation (full
consolidation, no consolidation, etc.).8 Following AJLZ, we consider data
prepared according to domestic standards and full consolidation for our
primary sample.9
For each firm-year, we compute the following: levels and changes for
annual earnings and cash flow from operations, market value of equity at
the beginning of the fiscal year, and common stock returns for 15 months
ending 3 months after the fiscal year-end.10 The definitions of account-
ing variables and the GlobalVantagedata item numbers used to obtain the
data are as follows: Earnings (E) = earnings before extraordinary items
(#32). Cash flow from operations (CFO) = earnings before extraordinary
items (#32) + depreciation and amortization (#11) + deferred income
taxes (A#105) + untaxed reserves (A#108) + change in other liabilities
(A#109) + minority interest (#27) - change in noncash working capital
[A(#75 - #60 - #73) - A(#104 - #94 - #102)]. Noncash working capital is

7 The Spending on Auditing Servicesvariable has missing data for two countries. Our
conclusions do not change when we drop this variable from the factor analysis.
8 See footnote 18 of AJLZ for details.
9 Given that the level of consolidation of financial statements is a function of the national
accounting standards, we repeat our analysis after adding firm-years with data based on
partial or no consolidation. The additional observations belong to Belgium, Germany,
Japan, and Switzerland. Our conclusions are not affected. This is not surprising given that
for these four countries (i) the financial data are predicted to have low value relevance, and
(ii) AJLZ show that the value relevance of unconsolidated data is less than that of consol-
idated data.
10AJLZshow that their results are not sensitive to using (i) a 15-month return period
ending 3 months after the fiscal year-end for all countries or (ii) a return period of 15
months ending on the latest date allowed in the country on which the firm can present its
annual report for shareholder approval. Following AJLZ, we report our results based on
the first approach.

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10 ASHIQ ALI AND LEE-SEOK HWANG

defined as total current assets less cash, short-term investments, and trea-
sury stocks minus total current liabilities less debt in current liabilities
and proposed dividends.1"
Table 1 reports the number of firm-year observations satisfying the
data requirements for each of the 16 sample countries. We exclude ex-
treme observations (8.2% of the sample) by requiring that IAEitlPit-l I
' 1, IACFOit1Pit_1 | 1, 0 < PitlBVit' 5, and IEitlVit I' 0.5, where i is a
firm subscript, t is a year subscript, BV is book value of equity, and P is
stock price.12
For each of the non-U.S. country samples, we identify 100 samples of
U.S. firms matched on year, industry, and market capitalization. Follow-
ing AJLZ, to generate a matched U.S. sample for a country, for each
firm-year observation of the country we randomly select a U.S. firm in
the same year, two-digit SIC group, and market value of equity quintile
(based on NYSE/AMEXfirms). For each country, a U.S. firm may appear
in more than one matched sample, but not more than once in any
matched sample. Median measures for these U.S. samples are used as
benchmarks to control for year, industry, and firm size effects.

4. Alternative Measures of Value Relevance of Accounting Data

4.1 VALUE RELEVANCE OF EARNINGS

RegressionApproach.Following AJLZ, we estimate the value relevance

of earnings by using the following model:
Retit = ao + a1AEit/Pit_1 + a2EitlPit-l + i(1)

where Retitis the market-adjusted return for firm i and year t. The mar-
ket return of a country is specified as the return of an equally weighted
portfolio of all firms with data on the Global Vantage database.'3 The

"Data on deferred income taxes, untaxed reserves, and minority interest are some-
times missing. One reason is that these items are not separately disclosed, because they are
not material. For example, deferred income tax is quite small in countries with high align-
ment of financial and tax accounting rules. To avoid losing countries from our sample due
to insufficient observations, we assign a value of zero when data are missing for any of the
three items. This may introduce measurement error in our CFOmeasure. The use of in-
come statement and balance sheet (instead of statement of cash flow) items to obtain CFO
is another source of measurement error. Note that the data on earnings and book value of
equity, on which our primary results are based, do not have such measurement problems.
We repeat our analysis with a sample that does not require data for CFO.The sample size
increases by 4.4% and the results are similar to those reported in the paper.
12 Each of the four conditions by itself results in the deletion of 1.5%, 3.5%, 4.4%, and
2.9% of the total observations, respectively. We follow Joos and Lang [1994] in requiring
that 0 < PitlBVit< 5 and IEit/BVit|I 0.5.
13We follow Easton and Harris [1991] and Ali and Zarowin [1992] and use market-
adjusted returns in equation (1). Our method is similar to AJLZ's method of using raw re-
turns as the dependent variable, with annual intercepts to capture the mean annual returns

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 11

use of both earnings change and earnings level follows several recent
studies including AJLZ.
Equation (1) is estimated using a pooled time-series and cross-
section. Since we use 15-month returns as the dependent variable, the
consecutive-year data have overlapping return intervals and, therefore,
serially correlated regression residuals. We use generalized least squares
to consider such correlation. The serial correlation is assumed to be 0.2
(= 3/15) since the overlap is for 3 out of 15 months (see appendix A of
AJLZ for details).
Table 3 reports the R2s of equation (1) for all the countries. The ex-
planatory power of equation (1) is significant for all countries except
Sweden.'4 We also estimate equation (1) for each of the 100 matched
U.S. samples corresponding to each of the countries. We report the me-
dian R2 of equation (1) for the matched U.S. samples and the difference
between this median and the R2 of equation (1) for each country.'5 This
measure (DIFi) allows us to compare the explanatory power of earnings
across different countries, adjusted for differences in year, industry, and
firm size.16
Hedge Portfolio Approach. We also use AJLZ's hedge portfolio approach
to measure the value relevance of earnings. For each of the non-U.S.
country samples, earnings-based hedge portfolio returns are computed
assuming perfect foreknowledge of future earnings. Specifically, we form
an equally weighted hedge portfolio long in firms with the highest 40%
and short in firms with the lowest 40% of change in earnings for the
year. Portfolio returns (market-adjusted) are computed for the 15 months
ending 3 months after the fiscal year-end. Similarly, return-based hedge

for the sample. Moreover, our sample firms form most of the market portfolio for a
country. Since we use the GLSprocedure, the market-adjusted returns method is compu-
tationally easier.
14 Our sample differs from that of AJLZ because (i) the sample period is different, (ii)

we require sample firm-years to have data on cash flow from operations, and (iii) the out-
lier deletion rules are different. Nevertheless, we find that our results in table 3 are similar
to those of AJLZ, except that the R2 for Denmark is 0.640 in our study compared to 0.101
in AJLZ. We do a year-by-year analysis of Danish firms and find that the R2s are consis-
tently high. This suggests that (ii) and (iii) are most likely to be the reasons for the differ-
ence. When we repeat our analysis with the sample that drops data requirement for cash
flow from operations, R2 for Denmark falls to 0.249.
15We report R2 comparisons in order to be consistent with prior studies examining
value relevance of accounting data in the international context (see, e.g., AJLZ, Joos and
Lang [1994], and Harris, Lang, and M6ller [1994]). Following AJLZ, we also examine the
percentile of the 100 matched U.S. samples in which the non-U.S. sample R2 falls. This
analysis leads to the same conclusion as reported in the paper, as does analysis of the
model F-statistic.
16We repeat the analysis after replacing DIF1, a difference measure, with an equivalent
ratio measure. We perform this sensitivity check on other difference measures, defined
later in the study. Inferences are not affected in any of the cases.

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 13

portfolio returns are computed, assuming perfect foreknowledge of fu-

ture (15-month) market-adjusted stock returns. The ratio of the earnings-
based hedge portfolio returns to the return-based hedge portfolio returns
(hereafter, PRET) measures the proportion of all information impounded
in stock prices that is captured by accounting earnings. This approach
controls for intercountry differences in the dispersion of market-adjusted
returns, and unlike the regression approach, it does not impose a linear
relation between returns and earnings. However, the procedure does not
fully utilize information about the relative magnitudes of earnings within
each portfolio. Table 3 reports PRET for the non-U.S. samples, the me-
dian values of PRET for the corresponding 100 matched U.S. samples,
and their difference (DIFPRET). Results are similar to those reported by
AJLZ.
4.2 VALUE RELEVANCE OF ACCRUALS

Because accounting practices primarily influence accruals and not

cash, we examine separately the association between the value relevance
of accruals and country-specific factors. For this purpose, we estimate
the following models:
Retit = co + c1 AEit/Pit-l + c2EitlPit-1
+ c3ACFOit1Pit_1 + c4 CFOitPitP1+ uit (2)
= + +
Retit do d1 ACFOitPitP1 d2 CFOitPitP1 uit. + (3)
We obtain equation (2) by adding the CFO terms to equation (1). We
obtain equation (3) by replacing E in equation (1) with CFO.The R2 of
the returns model that includes earnings and CFO (equation 2) less the
R2 of the returns-CFO model (equation 3) gives the explanatory power
of accruals. The value relevance of accruals for a country relative to
the matched U.S. samples, DIF2_3, is given by the difference in R2s of
equation (2) and (3) for a country less the median of the difference in
R2s of equations (2) and (3) for the 100 matched U.S. samples. Table 3
reports the estimated values.
4.3 COMBINED VALUE RELEVANCE OF EARNINGS AND BOOK VALUE
OF EQUITY

Accounting rules in bank-oriented financial systems tend to empha-

size valuing balance sheet items to ensure that firms maintain sufficient
resources to repay debt (Joos and Lang [1994] and Gray, Campbell, and
Shaw [1984]). We therefore consider the value relevance of both earn-
ings and book value of equity.
Jo + fi BVit + f2 Eit + uit.
Pit =
To control for heteroscedasticity, we deflate the equation by BV to
obtain the empirical specification:'7

17If we use number of shares instead of BVas the deflator, the results are similar. How-
ever, White's test suggests the presence of heteroscedasticity when number of shares is
used as the deflator. We therefore report results with the BV deflator.

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14 ASHIQ ALI AND LEE-SEOK HWANG

PItlBVzt= fi + fo I/BVzt+ f2 EitlBVit+ uit (4)

To consider the effect of economy-wide factors, we estimate (4) with
annual intercepts. The R2s reported in table 3 do not include the ex-
planatory power of these intercepts. The table also reports DIF4, the
difference in R2 of equation (4) for a country and the median R2 of
equation (4) for the matched U.S. samples.

4.4 CORRELATION AMONG THE VALUE RELEVANCE MEASURES

Spearman correlations between the value relevance measures based

on the earnings-returns regression model (DIF1), the earnings-based
hedge portfolio (DIFPRET), and the price model with both earnings
and book value of equity (DIF4) range between 0.36 (p = 0.16) and 0.48
(p = 0.06). Only the correlation between DIF1 and DIF2_3 is high, 0.88
(p= 0.00). These results suggest that the alternative value relevance
measures are distinct, underscoring the importance of examining all of
them.

5. Results

Table 4 reports Spearman correlations between the value relevance

measures, DIF, DIFPRET,DIF2 3, and DIF4, and the variables represent-
ing country-specific factors. All correlations are in the predicted direc-
tions and significant at the 0.06 level or better. These results support the
hypothesized relations between value relevance and financial reporting
related country-specific factors.
Next, we examine the magnitude of the difference in the value rele-
vance of accounting data across countries, using our previously devel-
oped expectations. For this purpose, eight countries with high values of
Principal Factor, a composite measure of all the country-specific factors,
are assigned to group A, and the remaining eight to group B. Group A
(B) countries are expected to have high (low) value relevance. The first
analysis uses the regression-based value relevance measures of earnings.
The medians of DIF1 (defined as R2 of equation (1) less the median R2
of equation (1) for the 100 matched U.S. samples) for group A and
group B countries are -0.010 and -0.094, respectively. These medians
are computed using the DIF1 values reported in table 3. The medians
of the explanatory power of the matched U.S. samples (defined as the
median R2 of equation (1) for the 100 matched U.S. samples) corre-
sponding to the eight countries in group A and group B are 0.158 and
0.134, respectively. These medians are computed using values reported
in column 2 (R2 of equation (1), U.S.) of table 3. Thus, the value rele-
vance of accounting data for group A countries is, on average, 6.3% (=
0.010/0.158) less, and that of group B countries is 70.2% (= 0.094/0.134)
less than that for the U.S. The difference between the two groups is

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 15
TABLE 4
SpeanmanCorrelationsbetweenValueRelevanceMeasuresand VariablesRepresentingCountry-Specific
FactorsRelated to Financial Reportingfor 16 Countriesfor the Years1986-95
Spearman Correlations (p-Values)
Variables Expected Sign DIF1 DIFPRET DIF2_3 DIF4
Debt-Asset Ratio (-) -0.68 -0.46 -0.59 -0.52
(0.00) (0.04) (0.01) (0.02)

DomiesticFirms-to-PopulationRatio (+) 0.55 0.67 0.57 0.43

(0.01) (0.00) (0.01) (0.05)
Sourcesof GAAP (+) 0.61 0.61 0.48 0.56
(0.01) (0.01) (0.03) (0.01)

Accounting Cluster (+) 0.56 0.48 0.45 0.39

(0.01) (0.03) (0.04) (0.06)
Financial-Tax Alignment (+) 0.76 0.54 0.62 0.54
(0.00) (0.01) (0.00) (0.03)
Spending on Auditing Services (+) 0.55 0.52 0.55 0.49
(0.02) (0.03) (0.02) (0.03)
Principal Factor (+) 0.65 0.55 0.74 0.51
(0.01) (0.02) (0.00) (0.03)
Debt-AssetRatio = median debt-asset ratio of a country less the median debt-asset ratio of the
100 U.S. samples matched on year, industry, and firm size.
DomesticFirms-to-PopDulationRatio= ratio of the number of publicly traded domestic firms in a given country to its
population (in millions) in 1994.
Sourcesof GAAP = 0 if national accounting standards are set by governmental bodies only and 1
if private-sector bodies are also involved.
Accounting Cluster = 0 if the country is classified as a Continental model country and 1 if the coun-
try is classified as a British-American model country.
Financial-Tax Alignment = 0 if the level of alignment of financial and tax accounting is high and 1 if
the level of alignment of financial and tax accounting is low.
Spending on Auditing Semvices = total fees of a country's ten largest accounting firms as a percentage of the
country's gross domestic product for 1990.
Principal Factor = the principal factor obtained from a factor analysis, with input being the
above six variables.
DIF1 = difference in the R2 of equation (1) for a country and the median R2 of equa-
tion (1) for the 100 matched U.S. samples.
DIFPRET = difference in the PRET (see table 3 for definition) for a country and the
median PRETof the 100 matched U.S. samples.
DIF2.3 = difference in R2s of equation (2) and (3) for a country (representing the
explanatory power of accruals) less the median of the difference in R2s of
equations (2) and (3) for the 100 matched U.S. samples.
DIF4 = difference in the R2 of equation (4) for a country and the median R2 of equa-
tion (4) for the 100 matched U.S. samples.
Number of observations 16 (the number of countries in the sample). The Spending on Auditing Servicesvari-
able has data missing for two countries. Refer to table 1 for the list of sample countries, the values of the variables
representing country-specific factors, and the data sources. Refer to table 3 for the estimates of the value rele-
vance measures. The p-values are for one-tailed tests.

63.9% (= 70.2% - 6.3%). Differences that are similarly computed us-

ing DIFPRET DIF2_3,and DIF4, instead of DIF, are 23.3%, 63.0%, and
72.5%, respectively. These results indicate the magnitude of the differ-
ence in value relevance between two groups of countries expected to
have high versus low value relevance of accounting data.

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16 ASHIQ ALI AND LEE-SEOK HWANG

6. Control for the Price Leading Financial Reports Effect

Previous research (e.g., Jacobson and Aaker [1993]) suggests that,
relative to market-oriented countries, in bank-oriented countries, the
information in financial reports is more likely to be reflected in lead-
ing-period returns than in contemporaneous returns. This effect will
understate the contemporaneous returns-based value relevance measures
for bank-oriented countries, and thereby induce spurious association
between the value relevance measures and financial system characteris-
tics. We refer to such understatement as the price leading financial
reports effect. To document this effect, we use a procedure similar to
Kothari and Sloan [1992] and estimate the following two models:
Retl5it = ao + a, AEjtIPit-j + a2 EitlPit- + uit (5)
Ret24it = + b, AEjt/Pjtj + b2 EitlPit-l + uit (6)
Equation (5) is the same as (1), except that the return variable is re-
named Retl5it to indicate that it is for 15 months ending 3 months
after the end of fiscal year t. Equation (6) uses Ret24it defined as re-
turns for 24 months ending 3 months after the end of fiscal year t. The
earnings response coefficients in (5) and (6) are given by a, + a2 and
b, + b2, respectively (Ali and Zarowin [1992]). If all information in the
earnings of fiscal year t is reflected in the 15-month returns, then the es-
timates of a1 + a2 and b1 + b2 should be the same. If some of the earn-
ings information is incorporated in price beforethe 15 months, however,
then (b1 + b2) > (a1 + a2) (see Kothari and Sloan [1992]).18 Thus, the
ratio (a1 + a2)I(b1 + b2) reflects the extent to which earnings informa-
tion is captured in contemporaneous returns as compared to leading-
period returns.
Table 5 reports the estimates of a1 + a2, b1 + b2 and (a1 + a2)1(b1 +
b2) for all sample countries. Note that (b1 + b2) > (a1 + a2) except in
the U.K. sample and the matched U.S. samples for Ireland, suggesting
that in almost all sample countries some earnings information is incor-
porated in leading-period returns. The last column in table 5 reports
DIFTIME,difference in (a, + a2)I(b1 + b2) of a country and the median
for the matched U.S. samples. Comparison with the matched U.S. sam-
ples controls for the effect of year, industry, and firm size on the extent
to which earnings information is captured in contemporaneous returns
as compared to leading-period returns.19

18We use the 24-month window because (i) Kothari and Sloan [1992] show that for U.S.
firms there is not much increase in the earnings response coefficient when the returns win-
dow is increased beyond 24 months, (ii) Jacobson and Aaker [1993] use a 24-month win-
dow in the context of U.S. and Japanese firms, and (iii) for some countries the sample
becomes very small if we use a window that is longer than 24 months.
19The effect of firm size is documented for U.S. firms by Freeman [1987] and Collins,
Kothari, and Rayburn [1987].

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 17
TABLE 5
Price Leading Financial Reports Effect: Regressions of 15-Month and 24-Month Market-Adjusted Returns
on the Change and Level of Earnings (Sample Period = 1986-95)

Equations: Retlit = ao + a, AEitIPit-l + a2 EitPit-i + uit (5)

Ret24it = bo + b, AEit/Pit_1 + b2 Eit/Pit-1 + uit (6)

Earnings Response Median

Coefficient Using (a1 + a2)I(b1 + b2)
No. of Equation (5) Equation (6) (a1 + a2)I(b1 + b2) of U.S. Samples DIFTIME
Country Obs. a, + a2 b, + b2 (1) (2) (1)-(2)
Australia 404 2.08 2.15 0.97 0.90 0.07
Belgium 59 1.24 1.83 0.67 0.88 -0.21
Canada 1,063 1.09 1.19 0.91 0.91 0.00
Denmark 56 1.53 2.39 0.64 0.68 -0.04
France 496 1.45 1.90 0.76 0.80 -0.04
Germany 478 0.65 0.99 0.66 0.83 -0.17
Hong Kong 102 1.46 2.10 0.69 0.76 -0.07
Ireland 69 1.53 1.70 0.90 1.25 -0.35
Italy 105 0.51 0.71 0.72 0.78 -0.06
Japan 469 0.71 1.24 0.57 0.89 -0.32
Netherlands 269 1.52 2.01 0.75 0.98 -0.23
Norway 63 0.57 0.77 0.74 0.92 -0.18
Singapore 161 6.34 9.02 0.70 0.84 -0.14
Sweden 75 -0.01 0.15 -0.06 0.75 -0.82
Switzerland 106 1.16 1.43 0.81 0.90 -0.09
United Kingdom 1,998 1.28 1.08 1.18 0.84 0.34
Retlit (Ret24it) = returns for firm i for the 15-month (24-month) period ending 3 months after the end of fiscal year t, less
the return for the same period of an equally weighted portfolio of all firms for the country to which firm
i belongs.
Eit = annual earnings before extraordinary items for firm i and fiscal year t.
Pit-l = market value of common stock for firm i at the end of fiscal year t - 1.
DIFTIMIE = the difference in (a, + a2)/(b1 + b2) of a country and the median (a, + a2)/(b1 + b2) of the 100 matched
U.S. samples, where a, and a2 and b, and b2 are coefficients on AEitlPitP1and EitlPitP1in equations (5)
and (6), respectively.
The above results are based on a sample that is different from the one used in table 3. The additional requirement of 24-
month returns results in a loss of 437 (6.8%) firm-year observations.

DIFTIMEis correlated with the financial system characteristics, Debt-

Asset Ratio (Spearman correlation = -0.47; p = 0.03, one-tailed) and
Domestic Firms-to-Population Ratio (p = 0.42; p = 0.05, one-tailed). These
correlations indicate that, relative to market-oriented countries, bank-
oriented countries are characterized by a greater price leading financial
reports effect, that is, earnings information is reflected more in leading-
period returns than in contemporaneous returns. This result, based on
a sample of 16 countries, generalizes Jacobson and Aaker's [1993] com-
parison of Japan (a bank-oriented country) and the United States (a
market-oriented country).20
One implication of a greater price leading financial reports effect
for bank-oriented countries is that the contemporaneous returns-based

20Jacobson and Aaker [1993] do not control for the differences in firm size between
their two sample countries.

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18 ASHIQ ALI AND LEE-SEOK HWANG

value relevance measures are understated for these countries. This effect
may contribute to the relatively low value relevance observed for these
countries (tables 3 and 4). Other country-specific measures considered
in this study are correlated with the financial system measures (see ta-
ble 2). Thus, the price leading financial reports effect may also influ-
ence the correlations between contemporaneous returns-based value
relevance measures and the other country-specific measures.
We control for the price leading financial reports effect on the regres-
sion-based value relevance measure of earnings, DIF, as follows. First,
we divide the R2s of equation (1) by the estimated values of (1 + (a1 +
a2)/(b1 + b2)) of the corresponding countries. If the R2 for a country is
small because most of the earnings information is incorporated in lead-
ing-period returns, its estimate of (1 + (a1 + a2)/(b1 + b2)) is also small.
Thus, dividing R2 by (1+ (a1 + a2)/(b1 + b2)) provides an ad hoc adjust-
ment for the price leading financial reports effect.21 We use the adjusted
R2s to compute an adjusted DIF1 measure and refer to it as ADIF1.22We
similarly adjust the other value relevance measures to obtain ADIFPRET,
ADIF2 3, and ADIF4.
As indicated in table 6, the Spearman correlations between the ad-
justed value relevance measures and the measures of country-specific
factors are generally smaller than those based on unadjusted value rele-
vance measures. The greatest decrease is observed for the correlation be-
tween the hedge-portfolio-based value relevance measure of earnings,
ADIFPRET,and Debt-AssetRatio, a measure of financial system (from -0.46,
p = 0.04 in table 4 to -0.21, p = 0.21). This suggests that the price leading
financial reports effect inflates the correlations between unadjusted value
relevance measures and country-specific factors. However, most correla-
tions based on the adjusted measures of value relevance remain signifi-
cant at the 0.10 level or better, in the predicted direction. The exceptions
are the correlations of ADIFPRETwith Debt-Asset Ratio and Accounting
Cluster(p = 0.21 and p = 0.12, respectively). However, these two variables
are correlated with the other adjusted value relevance measures, ADIFI,
ADIF2 3, and ADIF4. Thus, the hypothesized relations between value rel-
evance and country-specific factors hold after controlling for the price
leading financial reports effect.

21We divide by 1 + (a, + a2)/(bj + b2) instead of (a, + a)/(b, + b2) because the ratio
is negative for Sweden. We repeat our analysis after dropping Sweden and dividing the R2s
by (a, + a2)I(b2 + b2) for the remaining countries. Results are similar to those reported in
the paper.
22An alternative method to reduce the price leading financial reports effect is to use
long windows for both returns and earnings variables (Easton, Harris, and Ohlson [1992]).
This procedure is not useful for our study because we are interested in comparing the
effect of differences in accounting practices on the value relevance of periodicaccounting
data. Using aggregate earnings of multiple years is likely to mitigate the effect of differ-
ences in accounting practices on reported earnings, because the effect on earnings of ac-
cruals diminishes as the period over which earnings are aggregated increases.

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 COUNTRY-SPECIFIC FACTORS RELATED TO ACCOUNTING DATA 19

TABLE 6
SpearmanCorrelationsbetweenValueRelevanceMeasuresAdjustedfor the Price Leading
Financial ReportsEffect and VariablesRepresentingCountry-SpecificFactorsRelated
to Financial Reportingfor 16 Countriesand for the Years1 986-95
Spearman Correlations (p-Value)
Variables Expected Sign ADIFI ADIFPRET ADIF2_3 ADIF4
Debt-Asset Ratio (-) -0.66 -0.21 -0.58 -0.50
(0.00) (0.21) (0.01) (0.03)

DomesticFirms-to-PopulationsRatio (+) 0.54 0.53 0.54 0.39

(0.02) (0.02) (0.02) (0.07)

Sources of GAAP (+) 0.61 0.50 0.45 0.56

(0.01) (0.02) (0.04) (0.01)

Accounting Cluster (+) 0.53 0.31 0.42 0.34

(0.02) (0.12) (0.05) (0.10)

Financial-Tax Alignment (?) 0.73 0.38 0.60 0.51

(0.00) (0.07) (0.01) (0.02)

Spending on Auditing Services (?) 0.59 0.59 0.56 0.45

(0.01) (0.01) (0.02) (0.05)

PrincijpalFactor (+) 0.62 0.38 0.70 0.46

(0.01) (0.09) (0.00) (0.05)
Debt-AssetRatio = median debt-asset ratio of a country less the median debt-asset ratio of the 100
U.S. samples matched on year, industry, and firm size.
Domiiestic Ratio = ratio of the number of publicly traded domestic firms in a given country to its
Fiinns-to-Population
population (in millions) in 1994.
Sourcesof GAAP = 0 if national accounting standards are set by governmental bodies only and 1 if
private-sector bodies are also involved.
Accounting Cluster = 0 if the country is classified as a Continental model country and 1 if the country
is classified as a British-American model country.
Fin-ancial-TaxAligpnment = 0 if the level of alignment of financial and tax accounting is high and 1 if the
level of alignment of financial and tax accounting is low.
Spendingon Auditing Services = total fees of a country's ten largest accounting firms as a percentage of the coun-
try's gross domestic product for 1990.
PrincipalFactor = the principal factor obtained from a factor analysis, with input being the above
six variables.
ADIF1 = definition is the same as DIF (see table 4) except that the R2s are divided by the
estimated values of (1 + (a, + a2) I (b1 + b2)) of the corresponding countries (see
table 5) to control for the price leading financial reports effect.
ADIFPRET = definition is the same as DIFPRET(see table 4) except that the PRETs are divided
by the estimated values of (1 + (a1 + a9)I (b1 + b2)) of the corresponding coun-
tries.
ADIF2_3 = definition is the same as DIF2_3 (see table 4) except that the R2s are divided by
the estimated values of (1 + (a, + a2) I (b1 + b2)) of the corresponding countries.
ADIF4 = definition is the same as DIF4 (see table 4) except that the R2s are divided by the
estimated values of (1 + (a1 + a2)I(b1 + b2)) of the corresponding countries.
Number of observations 16 (the number of countries in the sample). The Spending on Auditing Servicesvariable
has data missing for two countries. Refer to table 1 for the list of sample countries, the values of the variables repre-
senting country-specific factors, and the data sources. Refer to table 3 for the estimates of the unadjusted value rel-
evance measures, and to table 5 for the estimates of (1 + (a1 + a2)I(b1 + b9)), used to control for the price leading
financial reports effect. The p-values are for one-tailed tests.

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20 ASHIQ ALI AND LEE-SEOK HWANG

7. Conclusions
Using financial accounting data from manufacturing firms in 16 coun-
tries for 1986-95, we demonstrate that the value relevance of financial
reports is lower for countries where the financial systems are bank ori-
ented rather than market oriented; where private-sector bodies are not
involved in the standard-setting process; where accounting practices fol-
low the Continental model as opposed to the British-American model;
where tax rules have a greater influence on financial accounting mea-
surements; and where spending on auditing services is relatively low.
Results are robust to alternative measures of value relevance of fi-
nancial accounting data, including measures based on earnings (using a
regression and a hedge-portfolio approach), accruals, and earnings and
book value of equity combined. We show that the extent to which earn-
ings information is reflected in leading-period returns as compared to
contemporaneous returns is greater for bank-oriented than for market-
oriented countries. This feature potentially induces spurious associations
between value relevance measures and financial system characteristics.
Our results are robust to using value relevance measures adjusted for
this confounding effect.

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