The value relevance of dirty surplus accounting flows in The Netherlands

Abstract

Recently the Dutch financial reporting standard setters have taken steps to make dirty surplus accounting flows more visible to parties outside firms, either by eliminating their possibilities or by requiring comprehensive income-type statements. These steps are presumably based on the idea that dirty surplus accounting flows are relevant to investors and hence have to be visible to them.

Whether dirty surplus accounting flows are indeed relevant in firm valuation is an empirical issue. This paper, therefore, explores both the incremental and relative value relevance of dirty surplus accounting flows for the Dutch listed firms in the period 1988–1997, when their existence was relatively unhindered.

We find consistent evidence that both reported income and clean surplus income are relevant in explaining stock returns, though reported income seems a more relevant measure of returns in the period considered.

The results suggest that aggregated dirty surplus flows are not associated with stock returns with accumulation intervals up to 10 years; however, asset revaluations and currency-translation differences are at times incrementally relevant to returns.

Introduction

The relevance of accounting information, most notably earnings, is an important topic because of the potential use of accounting information for contracting and valuation purposes (Beaver, 1998, Watts and Zimmerman, 1986). Recently, financial reporting standard-setting bodies have come under attack for allowing potentially relevant dirty surplus flows¹ to be kept out of earnings. Dirty surplus accounting flows, e.g., goodwill write-offs, asset revaluations, etc., bypass bottom-line earnings and are taken directly to shareholders’ equity.

Two conflicting views exist about “dirty surplus accounting flows.” The exclusion of irrelevant dirty surplus flows from earnings could potentially enhance the quality of reported earnings. Reported earnings are formed on the basis of more persistent components if noisy flows would be taken directly to shareholders’ equity. Dirty surplus flows are used, in this case, as the means of improving reporting efficiency or, more specifically, earnings quality.

On the other hand, the exclusion of relevant dirty surplus flows could decrease the informativeness of accounting earnings.² For instance, the fact that value-relevant information is not disclosed in firms’ primary statements may hinder the investors’ ability to extract it in a timely and precise manner (O'Hanlon & Pope, 1999). Then it is likely that reported earnings are not a good indicator of stock returns.

In more and more countries standard setters apparently accept the second view, and they are eliminating dirty surplus accounting options to reduce managers’ discretions with regard to reported bottom-line earnings. For example, in the United Kingdom, the Accounting Standards Board (ASB) effectively abolished extraordinary items in 1992 (FRS 3) and eliminated the dirty surplus treatment of goodwill write-offs in 1998 (FRS 10). In The Netherlands, the Council for Annual Reporting abolished the dirty surplus treatment of goodwill write-offs in 2000 (RJ 500.218).

The value relevance of dirty surplus items is an empirical issue. And also, given the costs of new regulations and the costs of enforcement, the issue arises over whether or not they deserve the recent special attention of standard-setting bodies.

The accounting research by Feltham and Ohlson (1995) and Ohlson (1995) can also motivate the attention directed at clean surplus accounting. In their residual income-based valuation framework, firm value is directly linked to observable accounting numbers given that the financial statements reconcile under the clean surplus relation.³ It implies that clean surplus income is considered as the summary performance measure in firm valuation. (Bernard, 1995, Dechow et al., 1999, Walker, 1997).

This study looks at firms listed in The Netherlands from 1988 to 1997. During that period, quite a few dirty surplus flows were allowed there. Since their existence was relatively unhindered, The Netherlands seems to be an interesting setting to investigate the relevance of dirty surplus items.

Moreover, although accounting practice in The Netherlands is considered to be similar to that in other common-law countries, such as the United Kingdom, and the United States (van Lent, 1997), Dutch investors are not thought to have much influence in company decision-making processes due to the Dutch policy of self-regulation for financial reporting in the private sector (DeJong, DeJong, Mertens, & Wasley, 2004) and the relatively weak position of its private sector regulatory body: Raad voor de Jaarverslaggeving (RJ). In the majority of Dutch listed firms, investors have little direct influence on the composition of the management and supervisory boards (with their two-tier co-optation system) because new board members are “self-elected” by the remaining members of that board.⁴

The freedom to choose financial reporting methods that the Dutch managers enjoy and the characteristics of the governance structure (Kabir et al., 1997, van Ees et al., 2003),⁵ therefore, could provide room for the existence of value-relevant dirty surplus items being kept out of firm's primary performance report, i.e., an income statement.

This paper investigates whether dirty surplus items are value relevant and whether clean surplus net income is more highly associated with stock returns than currently reported income. To the best of our knowledge, no other study on the value relevance of dirty surplus accounting flows has been done in The Netherlands.

To test the value relevance of dirty surplus flows empirically, we use the standard approach of examining the statistical association between dirty surplus flows and stock returns. We employ an incremental association method to test the informativeness of dirty surplus accounting flows. In addition, we also conduct a relative association study to compare the explanatory power (i.e., with respect to returns) of clean surplus income and reported income (under the Dutch GAAP).

Due to a potential mismatch of stock market and accounting information, it is suggested in the literature to extend the testing window over long periods (Easton et al., 1992, O'Hanlon and Pope, 1999, Warfield and Wild, 1992, October). Hence, we accumulate both stock market and accounting information in order to increase the power of the test.

Consistent with previous studies, we find that both currently reported income and clean surplus income are always relevant in explaining stock returns. But, reported income appears to be a better indicator of stock returns than clean surplus income.

The results also suggest that the aggregated dirty surplus flows are not relevant even with accumulation intervals of up to 10 years. However, there is some evidence that both the asset revaluations and the currency-translation differences are incrementally informative. Our data also indicate that goodwill write-offs are not relevant and the quality of earnings wouldn't have been enhanced in the testing period if the dirty surplus treatment of goodwill write-offs were abolished at that time.

The remainder of the paper is organized as follows. In the next section, we discuss dirty surplus accounting and provide some empirical evidence on the value relevance of dirty surplus flows. The third section discusses dirty surplus accounting possibilities in The Netherlands. The fourth section describes the hypothesis development and the research design. The data analysis and the empirical results are presented in the fifth section. In the final section, we conclude the paper and provide suggestions for future research.