40 (2005) 391–393

Discussion

Commentary on differences in the valuation of

earnings and book value: Regulation effects or

industry effects?

Martin Walker

University of Manchester, United Kingdom

This study contributes to the growing literature on cross-country differences in the

value relevance of earnings and book value, focusing on the United Kingdom, France,

Germany, and the Netherlands.

The paper highlights four issues:

1. The potential improvements in value relevance obtained by partitioning earnings into

its cash and accruals components.

2. The potential improvements in the explanatory value obtained by partitioning the

sample according to industry.

3. The potential improvements in the explanatory value obtained by partitioning the

sample according to country.

4. How the out-of-sample forecasting performance of the model varies according to the

partitions outlined above.

The authors find that the cash/accrual partition is only significant in the Netherlands

and the United Kingdom. This result extends to the out-of-sample forecasting performance

of the models when one allows the parameters of the model to vary by country. However it

makes no difference in the pooled model, or when parameters vary by industry but not

country. The authors do not present results that allow for both industry and country

variation.

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In general the authors find, both in-sample and out-of-sample, that the model

improvements achieved by allowing industry variation in the parameter values is greater

than that achieved by allowing cross-country variation. This suggests that fundamental

industry effects are more important than the cross-country differences that, the authors

argue, are mainly due to differences in accounting rules and practices.

I believe the results of the authors are interesting, and worthy of further development.

However, I also do have one major policy concern about the paper, and a number of

suggestions for further development of the work.

1. The ir/relevance of value relevance

The paper adopts a value relevance perspective. However, financial reporting also

serves a contracting and stewardship role that is arguably more important than value

relevance.

I doubt if the unfortunate external shareholders of Parmalat and Enron would thank you

for knowing that the association with share price and earnings was high. This is a major

problem for any attempt to draw policy conclusions from linear information models. Such

models take the cash flows as exogenously given. In the LID context, accounting serves no

economic role. The accounting numbers simply reflect information that is already known

to all economic agents. Accounting numbers do not affect investor or managerial

behaviour in such models.

In order to draw policy conclusions we need to be able to model accounting in a context

where managerial and investor behaviour and cash flows are bcausedQ by accounting; i.e.,

we need to be able to model how behaviour changes when accounting changes. LID

models are irrelevant for this task.

Consider, for example, what we would conclude if we found that the LID estimates

were identical across all countries and all industries. Would this imply that accounting was

perfect? Clearly not; for if accounting was universally poor across all EU states, then the

LID models could still yield identical fitted values.

In thinking about policy relevance we should really be thinking about the regulation of

the financial-communication and corporate-governance system as a whole. The formal

accounting numbers are just a cog in a much bigger machine. In designing a car it is

important to have a good gear box, but one would not design an entire car around the gear

box. So long as there are major differences in disclosure, other market regulations, and

legal/governance regimes, it is far from obvious why one would want to pursue equality of

the value relevance of accounting numbers as a desirable policy objective.

2. Suggestions for further work

The model adopted in the paper assumes unbiased accounting. There are better models

around that allow for ex ante conservative accounting.

The model does not allow for Basu-type earnings conservatism. Basu-type models are

inherently non-linear and do not mix well with LID models. Given the now massive

M. Walker / The International Journal of Accounting 40 (2005) 391–393 393

empirical support for the existence of Basu conservatism this is a major weakness of the

LID approach to value relevance.

The paper makes no attempt to control for disclosure differences. More general versions

of the LID model allow for other information, and this might be a way to capture

differences in disclosure. For example one might use analysts’ forecasts to back out

estimates of other information, to the extent that such forecasts reflect other disclosures.

The model makes no attempt to distinguish between normal and discretionary accruals.

The results could change if total accruals were further partitioned in this way. I suspect for

example, that the null accruals effects for Germany and France might change if this is

done.