VALUE RELEVANCE OF ACCOUNTING EARNINGS AND ITS COMPONENTS

CHAPTER ONE

 INTRODUCTION

1.1    GENERAL DESCRIPTION OF THE STUDY

The significance of accounting earnings for equity and firm valuation has been a topic of considerable research since the 1960s. Accounting earnings could simply be defined as the excess of income over expenditure, the earnings which is usually reflected in the financial statement of a company is usually obtained in line with the accrual concept which recognizes all income and expenses earned or incurred in a particular period irrespective of whether cash has actually been received or paid. Also, this earnings figure in the financial statement is made up of various components such as the earnings before interest and tax, earnings after tax, earnings after tax and extra-ordinary items etc.

In this context, accounting earnings would be considered as a source of information to be used by investors and analysts to enable them have an idea about the real performance of companies and also aid them in firm valuation. The value of a firm could be seen as a function of its future performance and this future performance depends on realized accounting earnings which are normally disclosed in the firm’s financial statements.

Since earnings are said to be a determinant of the value to be placed on a firm; the question would arise as to how value relevant is earnings? Earnings would be considered to be value relevant if it is able to capture and summarize the firm’s value. The value relevance would be measured as a statistical association between the financial statement earnings and the market value of the firm and earnings would be said to have quality if it is able to predict its future value.

1.2          BACKGROUND OF THE STUDY

Researches in this field of study began from the seminal work of Ball and Brown (1968) and Beaver that showed empirically the utility of accounting earnings is supposed to be relevant to appreciate the real performance of the company.

Previous studies have used different accounting variables as proxies of firms’ performance but ended up in disappointing conclusions; indeed the explanatory power of these regression models were weak, Lev (1989) attributed this result to the bad quality of accounting information.

Two studies have been developed which allows for the testing of the value relevance and the information content they are the event studies and the association studies. The event studies involves the examining of prices after the announcement of accounting information and measuring the abnormal returns which reflects a reaction of investors further to this event and the adjustment of share pries thus showing the information content.

The association studies consist of estimating regression models of market performance of the company on its financial information.

1.3          SCOPE OF STUDY

The study would cover the content analysis of the financial statements of companies in the banking and insurance sectors quoted on the Nigerian Stock Exchange between 2004 – 2008. The Nigerian Stock Exchange over the period of 2004 – 2008 has been selected because of the rapid growth which has been recorded during this short period and also the possibility of direct data collection. The findings in this paper would not be generalized to all emerging markets but, rather it can be used as a starting point for future studies and debate.

1.4          SIGNIFICANCE OF THE STUDY

It would aid investors by reducing uncertainties and information asymmetry and also boost their confidence in the use of financial statements information.

The value relevance of earnings would assist financial analysts in determining if earnings poses the desired quality to be relied upon for firm valuation.