THE INFORMATION CONTENT SIMULTANEITY OF RETURNS AND EARNINGS: THE CASE OF INDONESIA




Simposium Nasiona Akuntansi 9 Padang

THE INFORMATION CONTENT SIMULTANEITY OF RETURNS AND EARNINGS: THE CASE OF INDONESIA

FUAD*

Universitas Dian Nuswantoro, Semarang

DWI RATMONO

Universitas Diponegoro, Semarang

ABSTRACT

This paper analyzes in detail the information content of returns and earnings, both linearly and simultaneously because they are jointly affected by information that is difficult to specify explicitly. Based on empirical evidence, we challenge the assumption that earnings follow first order moving average process, while assuming that they actually follow first order autoregressive process. Using 900 firm-specific observations from 1996 to 2004 we found that earnings (ERC) and returns response coefficients (RRC) provide similar estimates under joint estimation rather than linear one. We also found that 2-Stage Least Square (2SLS) reduces the bias of ERC and RRC in contrast to under Ordinary Least Square. Surprisingly, earnings and returns convey information larger in the short-term rather than in the long-term. In particular, we found that one year lag of return contain more information about future earning than two-or three years lag of return.

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Keywords : Joint Estimation, Earning Response Coefficient, Return Response Coefficient, Information Content Bias.

* Corresponding author: Fuad, Universitas Dian Nuswantoro Semarang, Jl Nakula I No 5-11 Semarang, 50131. Email address: tofuad@gmail.com. Tel 0858 652 74745. Fax No: 024-356 5441 Padang, 23-26 Agustus 2006 K-INT 01 1

Simposium Nasiona Akuntansi 9 Padang

I. INTRODUCTION

One of the most compelling and intriguing research questions of our time is exploring the relationship between return and accounting earning, in which capital market equilibrium can be characterized by as a mapping from states into a set of security returns. Similarly, earnings are signals from information system which is a mapping from states into signal. In general, there could be any relationship between returns and earnings depending upon the nature of the two mappings. If one assumes that return and earnings reflect a common set of events, it is not unreasonable to assume that the two might be associated (Beaver, et al. 1979).

Thus, it can be argued that returns lead to earnings, while on the other occasions the direction is reversed. These two regressions have previously been estimated separately. Beaver et al. (1997), however, develop a new method, in the context of this accounting literature, for exploring the bivariate relationship between security returns and accounting earnings. The key innovation by Beaver et al. (1997) is to characterize the return-accounting earnings relationship as a system of simultaneous equations. They argue that “earnings and returns can behave as if they are both endogenously determined because they are jointly affected by information that is difficult to specify explicitly”. Nevertheless, prior research provides some limited and mixed evidence of a positive association, even after controlling for various informational and environmental variables (see Kothari, 2001 and Beaver, 2002).

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