Earnings Quality, Risk-taking and Firm Value: Evidence from Taiwan

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1 DOI: /IPEDR V Earnings Qualy, Risk-aking and Firm Value: Evidence from Taiwan Lu, Chia-Wu 1+ 1 Deparmen of Finance & Cooperaive Managemen, Naional Taipei Universy, Taiwan Absrac. This research examines he relaionship of earnings qualy, risk-aking and firm value. There has wo hypoheses been consruced, firs, a firm wh lower earnings qualy, which represens lower financial reporing qualy, will has higher degree of risk-aking; and second, ha lower accrual qualy firm has significan influence on reducing firm value, even afer conrolling he size, B/M raio, Amihud ILLQ and expeced defaul probabily proxies. This projec uses Taiwan sample daa during 2001 o 2010 and employing mulivariae regression analysis, he resuls shows ha he wo hypoheses are verified and he phenomenon is especially significan afer he 2008 financial crisis. Keywords: Earnings qualy, Risk-aking, Expeced defaul probabily 1. Inroducion and Leraure Review The accouning qualy, which can influence a firm s informaion risk, has being an imporan role in recen financial sudies. Since Dechow and Dichev(2002) develop he economeric model o measure earnings qualy, here are a lo of aricles o explore he influence of accouning qualy on differen corporae finance issues. In his paper I focus on how he accouning qualy affec risk choices in corporae invesmen and firm value. By leraures, here are several sudies have discussed he influence of earnings qualy on corporae finance issues. Wang(2006) invesigaes he relaion beween founding family ownership and earnings qualy, finding consisen evidence ha founding family ownership is associaed wh lower abnormal accruals, greaer earnings informaiveness. Biddle e al.(2009) provide evidence ha firms wh higher financial reporing qualy also are found o deviae less from prediced invesmen levels and show less sensivy o macro-economic condions. Wh IPO daa in UK, Ball and Shivakumar (2008) shows firms on average improving heir financial reporing qualy prior o an IPO, in order o mee he marke demand for higher qualy financials from public firms, and in response o public-firm regulaion. Rajgopal and Venkaachalam(2011) find ha deerioraing earnings qualy is associaed wh higher idiosyncraic reurn volaily over of US daa. However, here are sill rare papers o explore how he accouning qualy affecs he degree of risk-aking and firm value. 2. Hypoheses The primary goal of he analysis is o deermine he effec of earnings qualy on risk-aking and firm value. In leraures, here are some close linkages of he similar issue. Gray e al.(2009) sugges while accruals qualy impacs on he cos of capal for Ausralian firms. Rajgopal and Venkaachalam(2011) find ha deerioraing earnings qualy is associaed wh higher idiosyncraic reurn volaily over of US daa. Callen e al.(2012) empirically sugges ha poor accouning qualy increase he cos of equy. Therefore, can be inferred ha a firm wh lower accrual qualy (higher AQ value as menioned in secion III) will ake more risk: Hypohesis 1: A firm wh lower earnings qualy (higher AQ value) will has higher degree of risk-aking. Secondly, his research would also like o discuss lower earnings qualy affec firm s value. The sample period is divided ino wo periods by worldwide financial crisis 2008, checking he differen degree of earnings qualy effec on firm s value. Therefore, he hypohesis 2 can be developed as: +1 Corresponding auhor., Tel:(886) ex.67715, Fax:(886) chiawu@gm.npu.edu.w 119

2 Hypohesis 2: A firm wh lower earnings qualy (higher AQ value) will has lower firm value, even conrolling relaive variables. In addion, he influence of earnings qualy on firm value is more significan afer financial crisis 2008 han before. 3. The Model This secion inroduces he proxies of accrual qualy and risk-aking respecively, he regression models of his sudy, and he daa used The Measure of Earnings Qualy This research employs he accrual esimaion error measure developed by Dechow and Dichev (2002) and modified by Francis e al. (2005) as he measure of accruals qualy. Accruals qualy is defined as he degree of mapping for a firm s working capal accruals for he pas, curren and fuure operaing cash flows, conrolling for changes in revenue and he level of gross propery, plan and equipmen. Where TCA β PPE + ν (1). = 0i 1 icfoi,-1 2iCFOi,- 1 3 icfoi,+ 1 4iΔREVi, 5i CFO TCA = NIBE = ΔCAi, ΔCLi, ΔCashi, + ΔSTDEBTi, i, (ΔCAi, ΔCLi, ΔCash + ΔSTDEBTi, DEPN Tha TCA = oal curren accruals, CFO =cash flow from operaions. CA= curren asses, CL= curren liabily, STDEBT= deb in curren liabily, DEPN= depreciaion and amorizaion, NIBE= ne income before exraordinary ems, ΔREV=changes in sales revenue, and PPE= gross value of propery, plan and equipmen. All variables in equaion (1) are scaled by average oal asses over year -1 and year. Refer o Francis e al. (2005), he coefficiens in Eq. (1) will likely differ across indusries, since his research esimae equaion (1) cross-secionally by year and whin each of he Taiwan Securies Exchange indusry classificaions, which mus conain a leas 10 firms in year. Annual cross-secional esimaions of equaion (1) yield he residuals ν, and he accruals qualy measure AQ= σ ( νˆ ),where σ ( νˆ ) is he sandard deviaion of firm i s residuals, νˆ, calculaed over year -5 hrough year -1. Higher value of AQ means lower degree of earnings qualy The Measure of Risk-aking This research use wo proxies o measure he degree of risk-aking: Expeced defaul probabily (EDP) and sock reurn volaily, which are similar o Erkens e al.(2012). EDP is implemened by Meron's (1974) srucural form model, which has been usually used as a cred risk measure in pracices (Moody s KMV, Crosbie and Bohn, 2003) or academic sudies (Vassalou and Xing 2004, Covz and Downing 2007). Taking a firm s equy as a call opion wh firm asse value as he underlying asse and s defaul hreshold as he exercise price, esimaing he asse marke value and volaily of a firm by employing an opion heory-based mehod developed by Black and Scholes (1973) and Meron (1974). A firm s asse value is denoed as V, which follows log-normal sochasic process, σ V indicae he sandard deviaion of asse value, is he remaining ime o maury of a firm s liabilies D, μ denoes he rae of growh of asse value. EDF 2 V σ V ln + μ = D N 2 σ V N[] : Cumulaive Normal Disribuion Second, also referring o Erkens e al.(2012), his sudy measures sock reurn volaily as he sandard deviaion of weekly sock reurns. The sock reurn volaily is calculaed by 52 weekly sock reurns during every year in he sample period Empirical Regressions To observe he influence of accrual qualy on risk-aking, he univariae regression is employed: i, ) (2) 120

3 Risk_akin g = α AQ + ε (3) Where risk-aking can be proxied by wo measures, EDP and sock reurn volaily, as menioned above. If he coefficien β shows significan resuls, he Hypohesis 1 could be confirmed empirically. Then, he Hypohesis 2 discusses he influence of accrual qualy o firms value, can be es by he following regression: Tobin _ Q = β 0 1AQ 2 log size 3( B / M ) 4 Amihud 5EDP + ε (4) Where Tobin s Q is proxied for firm value, which are used in prior leraures(gompers e al., 2003; Morey e al., 2009, Chi and Lee, 2012) Tobin s Q is calculaed as he book value of asses plus he marke value of equy minus he book value of equy and deferred axes, all divided by he book value of asses. Furhermore, he conrol variables including log value of firm size (book value of asse), book o marke value of firm equy (B/M raio), Amihud (2002) illiquidy proxy and Expeced defaul probabily (EDP). They are usually being conrolled in relaive sudies Sample Daa The sudy uses lised firms daa in Taiwan Sock Exchange. All daa are aken from he Taiwan Economic Journal (TEJ), including ransacion daa and financial saemen maerials. The sample period composes during 2001 o Empirical Resuls and Conclusion Table 1 shows he resuls of esing Hypohesis 1. Boh proxies of risk-aking (EDP and Sock Reurn Volaily) are significan influence by AQ. Because higher AQ represens lower earnings qualy, higher AQ will induce higher degree of risk-aking. The resuls of Table 1 denoe higher AQ (lower earnings qualy) has posive significan impacs on firm s risk-aking, which is consisen wh Hypohesis 1. In addion, he adjused R-square of AQ regress on EDP is only 0.78%, which is much smaller han ha of Sock Reurn Volaily 5.98%. Explanaory Variables Inercep AQ Table 1: Univariae Regression of Risk-aking on Accrual Qualy EDP (28.89)*** (8.47)*** Sock Reurn Volaily (96.25)*** (24.14)*** Adj R 2 (%) No. of Observaions This able shows he resuls of univariae regression of risk-aking on accrual qualy. The dependen variable of risk-aking proxies includes EDP and Sock Reurn Volaily. EDP is he expeced defaul probabily which is calculaed by Meron's (1974) srucural form model, which has been menioned as Eq.(2). Sock Reurn Volaily is he sandard deviaion of weekly sock reurns, calculaed by 52 weekly sock reurns during every year in he sample period, referring o Erkens e al.(2012). AQ denoes Accrual Qualy developed by Dechow and Dichev (2002) and modified by Francis e al. (2005) as menioned in secion IV. Values in parenheses are -value, and *,**,*** represen 10%, 5% and 1% significance level respecively. Table 2 shows he mulivariae regression resuls of esing Hypohesis 2. I can be seen ha higher AQ (lower earnings qualy) has negaively significan influence he firm value proxies (Tobin s Q) even conrolling he size, B/M raio, Amihud ILLQ and EDP variables. During he oal sample period, he coefficiens of AQ is significance a 1% level; however, he degree of significan reduces as before 2008 financial crisis, only slighly significan a 10% level, conras o he period afer 2008, ha coefficien rise o and significan a 1%. Hence, he adjused R-square of he regression also rises 121

4 from 7.52% o 10.23% afer financial crisis. Therefore, he hypohesis 2 saemen, ha a firm wh lower earnings qualy (higher AQ value) will has lower firm value, and he influence of earnings qualy on firm value is more significan afer financial crisis 2008 han before, can be suppored by empirical evidences. Furhermore, can also be aken aenion how ha four conrolling variables affec Tobin s Q. Since all he conrolling variables has significan impacs (1% level) on firm value, he coefficiens of conrol variables: size (+), B/M (+), Amihud ILLQ (-) and EDP(-), denoes larger size, value-ype, higher liquid sock and lower expeced defaul probabily firms have higher firm values. In summary, he conribuion of his sudy is o explore he issue how he accrual qualy and risk-aking are conneced. From he empirical resuls, his sudy demonsraes ha higher earnings qualy is accompanied wh lower risk-aking and higher firm value. I also showed ha accrual qualy influence on firm value especially significanly afer he 2008 financial crisis. Table 2. Regression of Firm Value Proxy (Tobin s Q) on Accrual Qualy and Conrol Variables Sample Period Inercep AQ Log value of Firm Size B/M Amihud EDP All ( ) (11.86)*** (-3.61)*** (16.56)*** (8.72)*** (-3.96)*** (-9.88)*** Explanaory Variables : Tobin s Q Before Financial Crisis ( ) (7.82)*** (-1.79)* (15.04)*** (7.95)*** (-2.67)*** (-3.28)*** Afer Financial Crisis ( ) (10.11)*** (-4.24)*** (7.62)*** (4.36)*** (-3.34)*** (-11.81)*** Adj R 2 (%) No. of Observaions This able shows he resuls of regression of firm value proxy (Tobin s Q) on accrual qualy and conrol variables. The dependen variable is Tobin s Q. AQ denoes Accrual Qualy developed by Dechow and Dichev (2002) and modified by Francis e al. (2005) as menioned in secion IV. Firm size is log value of asse, B/M is he raio of book o marke value of firm equy, Amihud ILLQ proxy is calculaed by he mehod of Amihud (2002), EDP is he expeced defaul probabily which is calculaed by Meron's (1974) srucural form model, which has been menioned as Eq.(2). Values in parenheses are -value, and *,**,*** represen 10%, 5% and 1% significance level respecively. 5. References [1] Ball R. and L. Shivakumar, 2008, Earnings qualy a inial public offerings Journal of Accouning and Economics 45, pp [2] Biddle G.C.,G. Hilary, R. S.Verdi, How does financial reporing qualy relae o invesmen efficiency? Journal of Accouning and Economics 48, pp [3] Callen J.L., M. Khan and H. Lu, 2012, Accouning Qualy, Sock Price Delay and Fuure Sock Reurns, Conemporary Accouning Research, Forhcoming. [4] Dechow, P.M., Dichev, I.D., The qualy of accruals and earnings: The role of accrual esimaion errors. The Accouning Review 77 (Supplemen), pp

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