INFORMATIVENESS OF EARNINGS AND CASH FLOWS: EVIDENCE IN INDONESIA, MALAYSIA, AND THAILAND BANKING INDUSTRY Elisa Tjhoa, University of Indonesia Ancella Anitawati Hermawan, University of Indonesia Abstract Financial statements’ information, particulary net income and cash flows from operations has been widely used by investors as one of the basis in making investment decisions. Interests are the main source of income in the banking industry, and therefore the information of which are considered to have a significant role for the investors. The objective of this study is to examine the informativeness of earnings, cash flows from operations, and net interest income in the banking industry in three South East Asian countries, i.e. Indonesia, Malaysia, and Thailand. The hypothesis testing is carried out using multiple regression method with the sample of publicly listed Banks in each country during the year of 2006 to 2010. The empirical results show that net income of banking industry is informative in Indonesia and Thailand, but not in Malaysia. In Malaysia, cash flows from operations is more informative, similar to Thailand. In term of interest icome, Malaysia and Thailand indicates that this information is informative, but not in Indonesia. In Thailand, the cash flows for interest is also informative. Key words : earnings response coefficient, net interest income, cash flows from operations, cash flows for interest, bank.
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INFORMATIVENESS OF EARNINGS AND CASH FLOWS: EVIDENCE
IN INDONESIA, MALAYSIA, AND THAILAND BANKING INDUSTRY
Elisa Tjhoa, University of Indonesia
Ancella Anitawati Hermawan, University of Indonesia
Abstract
Financial statements’ information, particulary net income and cash flows from
operations has been widely used by investors as one of the basis in making
investment decisions. Interests are the main source of income in the banking
industry, and therefore the information of which are considered to have a
significant role for the investors. The objective of this study is to examine the
informativeness of earnings, cash flows from operations, and net interest income
in the banking industry in three South East Asian countries, i.e. Indonesia,
Malaysia, and Thailand. The hypothesis testing is carried out using multiple
regression method with the sample of publicly listed Banks in each country during
the year of 2006 to 2010. The empirical results show that net income of banking
industry is informative in Indonesia and Thailand, but not in Malaysia. In
Malaysia, cash flows from operations is more informative, similar to Thailand. In
term of interest icome, Malaysia and Thailand indicates that this information is
informative, but not in Indonesia. In Thailand, the cash flows for interest is also
informative.
Key words : earnings response coefficient, net interest income, cash flows from
operations, cash flows for interest, bank.
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1. Introduction
The information about the company or the market condition is very
crucial for capital market investors in making their investment decisions. Optimal
decisions need high quality information, i.e. relevant and reliable information.
One source of information that is available for the investors to evaluate the
company’s prospective performance is the income statement and cash flows
statements. Bruns dan Merchant (1990) state that the cash flows statement provide
better information, since the accrual basis used in the income statements allows
the company’s management to manage the earnings reported. But Cheng et al.
(1997) conclude that net income still have value relevance, and cash flows from
operations contribute an incremental value relevance on top of the net income.
The quality of earnings reported in the financial stements is considered
high if it can be a valid base to predict to future company’s performace, but this
quality is often difficult to measure (Dechow et al., 2010). One approach to
measure the earnings quality is based on the earnings response coefficient (ERC).
Investors perceptions about the quality of earnings is captured by how the
investors react to the earnings information in the capital market. Teoh and Wong
(1993) shows that investors are willing to pay a higher price for earnings of "high
quality" because the high-quality earnings are seen as sustainable profits.
Therefore, earnings quality is measured based on the response of investors on the
information content of accounting earnings (informativeness of accounting
earnings). The magnitude of the change of abnormal retuns associated with the
change in unexpected earnings is called the earnings response coefficient (ERC).
The ERC will be high if investors perceive the informativeness of earning is high,
meaning that the earnings quality is high.
Banks have a unique business process with its intermediaries roles in the
financial market. Eventhough the industry is very highly regulated due to the
nature of the business, the business risk of banking industry is relatively high.
The standard of financial reporting format is different from other industries to be
able to present the relevant business performance results. Therefore, it is
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interesting to know which information regarding the result of the operating
performance that represents higher quality information from the investors’
perspective. As one of the emerging countries, Indonesian economy is still rely
more on banks for the financial system than the capital market. The banking
industry has shown a high growth rate in the past two decades. The performance
of the banks stock price in the market is usually better than other companies,
therefore banks stocks are usually taken as the underlying asset of a mutual fund.
But some Indonesian banks have also experienced financial difficulties, which
ended up with merger or acquisition by other banks, or declared bankruptcy. In
order to evaluate the bank’s prospect in profitability and risks, investors may have
different perception for every information item in the financial statement
depending on their perceived quality of such information. This study examines
how the investor’s response for the information of earnings, cash flows from
operations, and net interest income reported by banks in Indonesia. In addition, to
be able to understand how the quality of banks financial report in Indonesia
compared to other countries, the study includes the banking industry in Malaysia
and Thailand. As the member of South East Asian Nations, the three countries in
this study assumed to have some similarities and differences in the
macroeconomics conditions, government regulations, and financial reporting
standards, therefore comparing among those countries for this study will provide
some more insight about the banking industry financial reporting quality.
2. Literature Review and Hypothesis Development
Research and empirical studies on the effect of earings on stock returns
has been done many times before. Ball dan Brown (1986) are one of the pioneers
in the research, and found that there were movements in stock price around the
company’s accounting income announcements. Kothari (2001) also finds strong
correlations between the stock price movements with the company’s income
movements. Dastgir et al. (2004) show that the correlation between net income
and stock returns is stronger than the correlation between cash flows and stock
returns. But in a research on effect of SFAS No. 95 Statement of Cash Flows on
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stock price movements, Cheng et al. (1997) find that both net income and cash
flows from operations have positive and significant impact on stock returns.
Chen (2009) concludes that both accounting income and cash flows from
operations has significant effect on price movements. But the effect of accounting
income is stronger in predicting stock returns in longer period, while the cash
flows from operation is stringer in predicting stock returns in shorter period.
Dastgir et al. (2009) performed a research to see the effect of income statements
and cash flows statements informations on the stock returns for Tehran Stock
Exchange, using the components of the reports as independent variables of the
research. The components of income statements used are gross profit, operating
income, income before tax and net income. While the cash flows statements
componenets used are cash flows from operating activities, cash flows from
investing activities and cash flows from financing activities. The result of the
study showed that the component of income statements with the most significant
effect on stock returns is net income, whereas the component of the cash flows
statements with the most significant effect on stock returns is cash flows from
investing activities.
The quality of earnings refers to the relevance of earnings in measuring a
company’s performance (Subramanyam and Wild, 2009). Besides, the quality of
earnings also can be defined as the conservatism level of reporting by a company,
in which the company with higher price to earnings ratio will indicate a higher
quality of earnings. Statement of Financial Accounting Concepts No. 1 (SFAC
No. 1) stated that financial reporting should provide information regarding the
company’s financial performance in certain period. Dechow et al. (2010) defined
the quality of earnings as earnings that provide information regarding a company;s
financial performance, which could influence the decision made by a decision
maker.
Earnings response coefficient could be defined as the measure of abnormal
market return of a stock as the response of unexpected component of earnings
announced by the company (Scott, 2009). Ambarwati (2008) describes that
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earnings response coefficient will be based in the investor’s expectation on the
earnings before its announcement. Approaching the earnings announcement date,
the information obtained and gathered by investors will also increase. If the actual
earnings is higher than the investor’s expectation, then there would be good news,
and investors will decide to buy the shares. On the other hand, if the actual
earnings is lower than what was expected, there would be bad news, and the
investors will decide to sell the shares.
Earnings response coefficient will be different for each company, and is
influenced by a number of factors. Biddle and Seow (1991) and Ahmed (1994)
show that earnings response coefficient will be significantly influenced by the
company’s characteristics. Teoh and Wong (1993) state that the auditors also
influence the company’s earnings response coefficient. Their study show that the
auditor’s quality, or auditor with bigger scale of reputation will be more reliable,
which is proved by the higher earnings response coefficient in companies audited
by Big Six audit firms. This is caused by the perception of the investor that the
financial reports audited by the big six audit firms are less vulnerable to
misstatements compared to those who were audited by non Big Six audit firms.
Study of earnings response coefficient on banking sector has been done by
Ariff dan Cheng (2011) for Asia Pacific countries such as Australia, South Korea,
Malaysia, and Thailand. In the study, in addition to observe the effect of total
earnings information on stock price movements, they also examine the effect of
disaggregated non-interest fee income information.This study finds that the total
earnings movement in the financial reports have a positive and significant effect
on stock price movement in all four countries. As for the effect of the change in
disaggregated non-interest fee income to the stock price, this study shows a
positive effect in Australia, South Korea, and Malaysia, but a negative effect in
Thailand. They also find that there is no association between the level of
disaggregated non-interest fee income and stock price movement.
Based on the study of Ariff dan Cheng (2011), the first hypotheses in this
study is:
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H1a : Unexpected earnings is positively associated with cumulative abnormal
return
Interest revenue and expense are the results of main operational activities
in banks. Therefore the financial statements users often reflect the operational
performance of banks for the net interest income achieved during a ertain period.
Based on the above, the second hypotheses of this study is:
H2a : Unexpected net interest income is positively associated with cumulative
abnormal returns.
This study would also observe the quality of components on cash flows
statements, so the third and fourth hypotheses are:
H3a : Unexpected cash flows from operations is positively associated with
cumulative abnormal returns.
H4a : Unexpected net cash flows from interest is positively associated with
cumulative abnormal returns.
3. Research Method
3.1 Data and Sample
The sample of this study are publicly listed banks in the stock exchange of
Indonesia, Malaysia, and Thailand during the period of 2006 to 2010. Table 1
shows that total sample is 30 banks, therefore the total observation for five-year
period for all countries is 150 observations. The list of the banks used as the
sample in this study is presented in the appendix.
The data used are from the companies annual report taken from the stock
exchange or company’s website, and also from Yahoo finance and Bloomberg..
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Table 1 Sample Determination
No. Sample Criteria Indonesia Malaysia Thailand
1 Number of Banks listed on the
stock exchange as of May
2012.
42 27 47
2 Banks that are listed during
the whole period of study
(2006-2010)
(10) 0 (2)
3 Banks with negative equity (1) 0 0
4 Banks with incomplete data (6) 0 0
5 Total sample 13 8 9
3.2.Research Model
The test on the above hypotheses are performed using the multiple
regression method, that is the effect of unexpected earnings and unexpected cash
flows from operations, and also unexpected net interest earnings and unexpected
net cash flows from interests on stock returns.
Hypotheses 1 to 4 will be tested using the following 2 models :
= + . + . + . + . +
. + . +
= + . + . + . + . +
. + . +
Where:
= cumulative abnormal return stock company i in year t
= unexpected earnings company i in year t
= unexpected cash flows from operations comapany i in year t
= unexpected net interest earnings company i in year t
= unexpected net cash flows from interest company i in year t
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= risk of company i measured by beta in year t
= loan to deposit ratio of company i in year t
= price to book value (PBV) ratio of company i in year t
= size of company i measured by outstanding shares times closing
price in year t
3.3 Variable Measurements
The dependent variable in this study is the company’s market adjusted
stock return proxied by the cumulative abnormal market adjusted return. Stock
price data used are the weekly closing price of public companues in banking
industry and weekly closing rice of the composite index on each country
observed. For companies with reporting period ended 31 December, the stock
return period used are from 1 April 2006 to 31 March 2011. For companies with
reporting period ended 31 March, the stock return period used are from 1 July
2006 to 30 June 2011. While for companies with reporting period ended 30 June,
the stock return period used are from 1 October 2006 to 30 September 2011.
( )
( )
( )
( )
From the above we could get weekly market adjusted return which were
cumulated for one year to obtain cumulative abnormal return which is the
dependent variable in this study.
∑
Where:
= stock return of company i in week w
= market return in week w
= stock price of company i in week w
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( ) = stock price of company i in week (w-1)
= stock exchange index in week w
( ) = stock exchange index in week (w-1)
= market adjusted return company i in week w
= cumulative abnormal return company i in year t
The independent main variables in this study comprised of unexpected
earnings, unexpected interest earnings, unexpected cash flows from operations
and unexpected cash flows from interests.
Proxy for unexpected earnings was calculated as follows:
( )
( )
Proxy for unexpected net interest earnings was calculated as follows:
( )
( )
Where:
= proxy unexpected earnings company i in year t
= earnings per share company i in year t
( ) = stock price company i in year (t-1)
= proxy unexpected net interest earnings company i in year t
= net interest earnings per share company i in year t
In this study, the proxy for unexpected cash flows from operations was
calculated as follows:
1
0
( )
( )
While the calculation for the proxy of unexpected cash flows from
interests will be as follows:
( )
( )
Where:
= proxy unexpected cash flows from operations company i in year t
= cash flows from operations per share company i in year t
= proxy unexpected net cash flows from interest company i in year
t
= net cash flows from interest per share company i in year t
The control variables includes:
Loan to Debt Ratio
Based on Mulyono (1995:101), the loan deposit ratio is the ratio that
compares funds distributed to the society as loans with the funds gathered from
the market and its own capital. The ratio describes the ability of the bank to repay
the depositor using the loans as its source of liquidity. The higher the ratio, the
lower the liquidity of the bank (Dendawijaya, 2000:118). The loan to deposit ratio
is calculated as follows:
1
1
Company’s Risk
The research by Murwaningsari dan Rachmanto (2011) showed that a
company’s risk can significantly influence the stock return. The company’s risk is
reflected in the company’s beta obtained by performing regression on weekly
stock return with the market return for each company observed. The beta value is
obtained using the following formula (Bodie et al., 2008):
Where:
= stock return company i for period t
= market return for period t
= intercept of regression between stock and market return
= slope of regression between stock and market return which
shows the response of stock return to movement of market price
regresi
Growth Opportunity
Senthilkumar (2009) and Tresnaningsih (2007) in their research proxied
the company’s growth opportunity using market price to book equity ratio. The
ratio is calculated as follows:
Company’s Size
Quiroz and Timmermann (1999) stated that the stock return is also
influenced by the size of the company, whereas the smaller the size of the
company, the more the chance to have asymmetric information which can
influence the company’s stock return.Based on the study of Siregar and Utama
(2008), the size of the company can be proxied by the market value of equity in
1
2
end of year, which is obtained by multiplying outstanding shares with closing
price at end of year.
4. Results
4.1 Descriptive Statistics
Table 2 shows that on average, the value of cumulative abnormal return CAR for
Indonesian banks in the sample is higher than the other two countries. Higher
return also means higher risks, and it is represented by higher standard deviation
Table 2 Descriptive Statistics
MINIMUM MAXIMUM
MEAN STANDARD DEVIATION
Indonesia Malaysia Thailand Indonesia Malaysia Thailand
Indonesia Malaysia Thailand Indonesia Malaysia Thailand