Information Content of Net Income and Other Comprehensive Income: Investigation of Japanese Firms

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1 Informaion Conen of Ne Income and Oher Comprehensive Income: Invesigaion of Japanese Firms Keiichi Kuboa Musashi Universiy and Chuo Universiy Kazuyuki Suda Waseda Universiy Hioshi Takehara Waseda Universiy This version: Ocober 5, 007 JEL Classificaion: M40, M4, G3 Keywords: oher comprehensive income, relaive informaion conen es, incremenal informaion conen es, Japanese GAAP, diry surplus The corresponding address: Keiichi Kuboa, Faculy of Economics, Musashi Universiy, -6-, Toyoama-kami, Nerima, Tokyo, Japan , Address: or This paper was presened a he 007 Asian Academic Accouning Associaion Meeing, he 007 European Accouning Associaion Meeing, and he 0h WCAE/IAAER Congress. The auhors hank Zhaoyang Gu, Yuji Ijiri, Carolina Koornhof, Takashi Obinaa, Eiko Tsujiyama, Akira Usui, Hiromi Wakabayashi, and Takashi Yaekura for heir helpful commens and discussion. The auhors also hank Gary Biddle a Hong Kong Universiy of Science and Technology for helpful privae correspondence. The auhors are graeful for financial suppor by Gran-in-Aid for Scienific Research from he Japan Sociey for he Promoion of Science(# , # , and #953049). All remaining errors are our own.

2 Absrac The paper invesigaes he informaion conen of ne income, oher comprehensive income iems, and pseudo comprehensive income for Japan. We choose changes in cumulaive foreign currency ranslaion adjusmens and changes in he balance of unrealized gains and losses on securiies available-for-sale as oher comprehensive income iems. The resul from he relaive informaion conen es shows ha ne income is one of he mos dominan income measures, which is also good or beer han alernaive pseudo comprehensive income numbers according o he Wald es. We also find ha he oher comprehensive income iems conain incremenal informaion conen from he F-es. However, we find ha signs of he esimaed regression coefficiens on hese oher comprehensive income are negaive, conrary o our iniial prior informaion. To furher invesigae his poin, we classify firm samples based on firm characerisics: he proporion of foreign firms and disribuions of cross-held shares by firms. We find ha for foreign oriened firms, unrealized gains are good news, while for cross-held firms, unrealized gains are bad news. We reconfirm his endency based on full-scale indusry-wise invesigaions. Finally, we argue ha, no maer wheher he news is good or bad, individual invesors could increase heir expeced uiliy by disclosing his oher comprehensive income informaion. Moreover, accouning conservaism would srongly recommend disclosure of bad news. Because oher comprehensive income iems are already disclosed as diry surplus in Japan, he exra cos of disclosing hose iems in comprehensive income repors will be minimal.

3 . Inroducion This paper addresses a quesion of wheher he disclosure of comprehensive income as well as oher comprehensive income iems helps invesors assess firms fuure sock reurns beer han he ne income currenly repored in Japan. The FASB saemen FAS 30 (FASB, 997) requires firms who abide by he U.S. GAAP o disclose oher comprehensive income and comprehensive income. These figures can be disclosed eiher in income saemens or in a separae saemen of sockholders equiy. Prior o he release of his FASB saemen, however, iems of oher comprehensive income were reaed as diry surplus iems and charged direcly o balance shees in he U.S. as is he case currenly in Japan. According o curren Japanese GAAP, i is required ha only hree iems of oher comprehensive income are repored as diry surplus iems; i.e., changes in foreign currency ranslaion adjusmens, changes in unrealized gains and losses from securiies available-for-sale, and revaluaion differences of land properies. The forma of he disclosure is such ha hese numbers are direcly charged o equiy iems of he balance shees. Noe ha he disclosure of he las iem is opional and o be repored only when firms choose o do so. For fuure imperaive convergence of Japanese accouning sandards wih he Inernaional Accouning Sandards (IASB, 005), empirical descripive assessmens of how and which comprehensive income and oher comprehensive income iems in Japanese financial saemens are relaed o sock reurns are an imporan ask which academic researchers wan o answer. Hopefully, our finding on sock reurns helps There are some Japanese companies who choose o use he U.S. GAAP, mos of which are companies whose socks are lised in he U.S. marke. Alhough he number of hese companies varies year o year, i is approximaely beween 5 and 30 firms. The Japanese Accouning Sandards Board is rying o conform o he Inernaional Accouning Sandards by 0. 3

4 Japanese accouning sandard seers o consruc useful accouning disclosure policies based upon he purpose of disclosing financial saemens for heir muliple users. Thus, in his paper we invesigae he informaion conen of comprehensive income and oher comprehensive income iems disclosed as diry surplus among Japanese companies. Since ne income is he boom line number in income saemens in Japan, we add he combinaions of oher comprehensive income numbers, and consruc alernaive comprehensive income numbers. We es he informaion conen of hese consruced numbers as well as he ne income per se and oher comprehensive income numbers. The paper proceeds as follows. We conduc empirical ess o invesigae informaion conained in hypoheical comprehensive income, employing a sandard research framework and es he informaion conen of accouning numbers. For his purpose we employ boh he relaive informaion conen es proposed by Biddle e al. (995) and he incremenal informaion conen es wih he F-es. Because he comprehensive income disclosure is no ye required in Japan, in his paper we have o consruc a pseudo comprehensive income using ne income afer ax as a benchmark figure and add oher comprehensive income iems o i. 3 Alhough here are only hree iems of oher comprehensive income which are currenly disclosed in he balance shees in Japan, we choose wo of hem: foreign currency ranslaion adjusmens, and unrealized gains and losses from securiies available-for-sale by he reason we will explain in he nex secion. Thus, we add combinaions of he above wo oher comprehensive income iems o ne income, and consruc various forms of he pseudo comprehensive income numbers. Given hese 3 Since hese oher comprehensive income numbers are recorded on balance shees using he sauory maximum corporae ax rae on an afer ax base, we simply add back hese amouns o he ne income afer ax. 4

5 alernaive measures of comprehensive income numbers as well as wo iems of oher comprehensive income we conduc several ess of informaion conen in he paper. Secion discusses he moivaion of he curren sudy and surveys previous lieraure in he field. Secion 3 describes our daa and he esing mehod. Secion 4 demonsraes he resuls of relaive and incremenal informaion conen ess. In secion 5 we firs spli our oal sample ino sub-caegories based on proporions of foreign sales and he raio of securiies available-for-sale o equiy of each firm and examine how he signs of he informaion conen of oher comprehensive income iems are differen beween hese sub-caegories of sample firms, and second, we confirm his resul wih indusry-wise observaions. Secion 6 concludes.. Moivaion and he Previous Sudies. Moivaion o Invesigae Accouning Informaion from Japan In Japan he comprehensive income disclosure is no currenly enforced, while some iems of oher comprehensive iems are direcly charged o equiy and disclosed as diry surplus iems on he balance shees. As he recen convergence effors by he IASB and he FASB move oward he disclosure of he comprehensive income across many counries (Doupnik and Perera, 007), i would be imperaive o empirically es he possible informaion conen conained in comprehensive income and oher comprehensive income iems for Japanese companies, because hey sill use he diry surplus disclosure of he seleced iems of oher comprehensive income in heir accouning sandards. 4 The curren research is one of few empirical inquiries using Japanese daa or oher Asian counries, which ry o answer his quesion and hopefully 4 Penman (00, p. 39) shows he various diry surplus iems currenly found in U.S. financial saemens. 5

6 will help Japanese accouning sandard seers suiably consruc disclosure rules relaing o comprehensive income numbers. The following hree iems are repored as diry surplus in Japanese financial saemens: foreign currency ranslaion adjusmens, unrealized gains and losses from securiies available-for-sale, and revaluaion differences of land properies. 5 The accouning sandards for foreign currency ranslaion adjusmens were revised in Ocober 999 along wih he newly enforced disclosure of consolidaed financial saemens in ha year. As for accouning sandards for reporing unrealized gains and losses from securiies available-for-sale, hey were firs released in January 999. As aforemenioned, land properies can be revaluaed only once during he 998 o 00 period when firms choose o do so. We do no include revaluaion differences of land properies because i was a valid disclosure rule wih opions for limied periods of ime. Accordingly, we selec changes in cumulaive foreign currency ranslaion adjusmens ( FCT)and changes in he balance of unrealized gains and losses on securiies available-for-sale ( SEC) as candidaes of he componens of oher comprehensive income. In his way we consruc he pseudo comprehensive income wih hese wo iems of oher comprehensive income. In his research we hypoheically consruc pseudo comprehensive income using he ne income afer ax as our benchmark measure and add he oher comprehensive income iems, which are all recorded on an afer-ax basis on balance shees wih he sauory maximum corporae ax rae, effecively per cen during our 5 Moreover, companies in Japan do no have o disclose minimum pension liabiliies as diry surplus iem on he balance shee. While less han 30 Japanese firms lised on he Tokyo Sock Exchange (TSE) are preparing heir financial saemen based on he U.S. GAAP and disclose minimum pension liabiliies, available daa for minimum pension liabiliies are very limied and we decided no o include minimum pension liabiliies as oher comprehensive income in our es. 6

7 observaion period. The research agenda we raise in his paper can be summarized in wo quesions saed below. These are proposed, firs, in view of he fac ha one of he ulimae objecives of financial reporing based on Japanese GAAP is primarily o consruc he meaningful and reliable ne income number. For his purpose he relaive informaion conen es of he pseudo comprehensive income numbers versus he ne income is called for. Second, even hough currenly he oher comprehensive income iems are only disclosed as diry surplus iems in Japan, we explore he informaion conen of hese disclosed numbers for fuure disclosure in income saemens. For his purpose he incremenal informaion conen of hese oher comprehensive income numbers is o be used. Thus, we raise he wo research quesions as follows. Q: Does he reporing of comprehensive income numbers enhance he informaion conen relaive o he reporing of solely he ne income numbers in predicing abnormal sock reurns? Q: Does each iem of oher comprehensive income possess incremenal informaion conen which is no ye conained in he ne income numbers in erms of predicing abnormal sock reurns? Noe ha our es of informaion conen uilizing he pseudo comprehensive income is a es under ceeris paribus condiions of he currenly disclosed financial saemen formas, and even if we were o be able o find evidence which suppors he 7

8 informaion conen of comprehensive income and oher comprehensive income iems, i would no unanimously provide us wih concree policy implicaions as o he usefulness of comprehensive income disclosure rules whenever such a rule is in fac enaced. 6 The reasons are wofold. Firs, by he usage of Ijiri (975, Ch. 3) he principal for Japanese accouning reporing would currenly be he ne income afer a ax number which we have chosen as our benchmark figure, and, in his sense, he predicions from our empirical findings may no be easily exended o a new disclosure regime unless people s concepion and behavior are safely assumed o be he same as before. 7 Second, as Holhausen and Was (00) argue, he found associaion beween he abnormal reurns and he accouning numbers may no direcly lead us o any accouning sandard seing policy saemen, mainly because he equiy holders are considered o be he only recipiens of accouning informaion in hese sudies. 8 Thus, such a finding may no be sufficien saisics for oher sakeholders surrounding he firms, alhough i is rue ha he addiional informaion conen of he accouning numbers found can increase he ex ane expeced uiliy of he individual equiy invesors (Demski, 003, Ch. 6), 9 assuming ha he addiional disclosure is cosless (Gonedes and Dopuch, 974, p. 77). Also, from an accouning conservaism viewpoin, we claim ha bad news should be disclosed, if i is found empirically o be he case. 6 We hank Takashi Yaekura for raising his poin during he presenaion of he earlier version of he paper a he 005 Japan Accouning Associaion Annual Meeing. 7 In oher words, we are also implicily assuming ha i does no maer how hese numbers are repored. Hirs and Hopkins (998) and Hirs e al. (00) conduc experimenal sudies o invesigae wheher he differen formas of comprehensive income reporing maer, and boh of hese sudies conclude ha he analyss are condiioned in he paricular way ha comprehensive income is presened 8 Barh e al. (00) couner argue agains heir viewpoin. We will no furher delve ino his conroversy, bu noe ha he firs cauion agains applying evidence from empirical accouning sudies direcly o a normaive accouning sandard seing was raised by Gonedes and Dopuch (974, p.5), saying, available evidence canno be used o fully resolve he main issues wih which hese bodies deal, jus around he ransiion ime from APB o FASB. 9.Noe he Sarbanes-Oxley Ac Sec. 305 (b) saes ha he SEC will ac upon any equiable relief for he benefi of invesors. 8

9 In spie of hose limiaions in our research, we believe ha i is a worhwhile empirical exercise o conduc, and he finding wheher here exiss (or does no exis) informaion conen in his pseudo comprehensive income and/or in oher comprehensive income iems will provide us wih a valuable clue in assessing he value of disclosed accouning informaion in Japan. We believe our sudy adds evidence o he inernaional accouning field.. Previous Value Relevance Sudies on Comprehensive Income Using he U.S. sample during he pre-sfas 30 period, Dhaliwal e al. (999) consruced he as if SFAS 30 comprehensive income and esed he value relevance. 0 They find ha heir as if SFAS 30 comprehensive income numbers do no exhibi a sronger associaion wih sock reurns han he convenional ne income number. The sudy also finds ha he available-for-sale markeable securiies adjusmens among financial services firms are significanly and incremenally priced. Furhermore, Biddle and Choi (006) invesigae he informaion conen of he as if oher comprehensive income, using he AR () model for income generaing process. Conrary o he finding by Dhaliwal e al. (999), hey find evidence which suppors he exisence of informaion conen of his as if oher comprehensive income for he U.S. daa. Laer, Chambers e al. (005) use he sample of he observaion period four years prior o ( ) and four years pos (998-00) inroducion of SFAS 30 for U.S. daa. They find a sronger associaion of sock reurns wih comprehensive income han wih he repored ne income for pos-sfas 30 periods, bu no for pre-sfas 30 periods. These resuls, hough no srong, provide evidence ha he 0 Dhaliwal e al. (999) use he erminology as if comprehensive income, while we use he erminology pseudo comprehensive income. 9

10 increased ransparency of new regulaions in SFAS 30 enhance he associaion beween sock reurns and comprehensive income. Furhermore and more ineresingly, hey find ha differen kinds of comprehensive income componens are informaive for differen indusries, of which poin we will also explore in his paper. As o he inernaional evidence, Kanagarenam e al. (005) find evidence of he value relevance of he componens of comprehensive income, using a sample of Canadian firms ha are cross-lised in he U.S. during pos-sfas 30 periods. In he case of U.K. firms, O Hanlon and Pope (999) do no find evidence ha he componens of oher comprehensive income are value relevan, while recenly Lin (006) finds ha oher comprehensive income, which is defined as all he recognized gains and losses aribuable o shareholders such as asse revaluaions and foreign currency ranslaion gains and losses, (Lin, 006, p. ) possesses significan incremenal price relevance. As for furher evidence for European counries, Ramond e al. (007) show srong evidence o suppor he view ha comprehensive income be repored, as recommended by he join IASB/FASB projec on Performance Reporing, using he mulinaional daa from Germany, France, Ialy, and Spain as well as from he U.K. In New Zealand i is required ha firms repor componens of oher comprehensive income in he Saemen of Movemens in Equiy, according o he Financial Reporing Sandards No.. Cahan e al. (000) use a sample of firms in New Zealand and invesigae he price behavior around he implemenaion even daes in January 995 of a FRS release. They compare he value relevance of he componens of oher comprehensive income before and afer he enacmen of reporing requiremens. They do no find any evidence ha componens of oher comprehensive income are valued 0

11 differenly even afer he reporing was required by FRS No.. This sudy is unique in he sense ha he New Zealand GAAP for oher comprehensive income reporing is differen from he U.S. GAAP, composed solely of wo componens: foreign currency ranslaion adjusmens and upward asse revaluaion differences. Finally, even hough we are no aware of any oher evidence from Asian counries excep for Japan, Wakabayashi (005) invesigaed he associaion beween sock reurns and comprehensive income, using he Vuong es for Japanese daa. Her finding is similar o ours, alhough he sampling designs and definiions she uses are differen and she also includes he revaluaion differences of he land properies as oher comprehensive income. As we will discuss below, her finding is similar o ours, and accordingly, he resuls for Japanese daa seem o be robus. Moreover, Kuboa e al. (006) examine he relaionship beween managemen compensaion and alernaive income numbers for he Japanese firm sample and find ha here is no difference in relaive informaion conen beween ne income and he as if comprehensive income for heir Japanese sample. 3. Daa and he Esimaion Mehod 3.. Daa Descripions Our sample consiss of he firms lised in he firs secion of he Tokyo Sock Exchange. In order o be included in our daa, we require ha a leas one iem of oher comprehensive income numbers are disclosed for each firm for each year. We also exclude financial firms from our daa because heir financial represenaions and he managerial moivaions of handling financial asses and liabiliies are fundamenally differen. The financial saemens daa sars from fiscal year 000 and ends in 004,

12 which covers five years of observaions. We include in he sample only firms whose fiscal year end on March 3 s because more han 90% of Japanese firms use he March fiscal year end and we wan o align he daa o accuraely measure he sock price movemens around he fiscal year end. The mos recen observaion is from financial saemens of March 3 s, 005, which is he end dae of fiscal year 004. Wih he above March fiscal year end crieria along wih an addiional imposed condiion ha a leas one of he oher comprehensive income iems is non-zero, we obain he minimum number of he sample of,98 firms in 005 and he maximum number of,305 firms in 004 during our sampling period. The oal firm-years are 4,994. Cumulaive abnormal sock reurn (CAR) is defined as an annualized Jensen s alpha which is measured based on he uncondiional Fama and French (993) hree facor model. In our regression analyses, we use monhly reurn observaions from 8 monhs before March 3 s o 3 monhs afer March 3 s. We use he Fama and French model o measure he sock reurn abnormal performance because his model is widely acceped as a sandard asse pricing model boh in he U.S. as well as in Japan (Jagannahan e al., 998). I is also because Beaver (00, p. 455) refers o he effec of marke-o-book raio in correcly measuring he unexpeced componen of sock reurns based on he marke efficiency heory. Thus, we ry o associae he surprise componens of he sock price wih he surprise componen of accouning numbers using he AR () expecaions formaion process of he accouning number ime series. As for capial marke daa, he daa source for accouning variables is he Nikkei NEEDS daabase provided by Nihon Keizai Shinbun Inc. and he source daa for he We also compued he cases for raw reurns and abnormal reurns from he CAPM. Deailed resuls are available upon reques from he auhors.

13 monhly reurn series is he Nikkei Porfolio Maser daabase provided by he Nikkei Media Markeing, Co., Ld. We use he inersecion of hese wo daa ses. Boh daa sources are free from survivorship bias and new lising bias. Table abou here Table presens he basic saisics of he variables used. All variables are deflaed by book values of oal asses a he end of he prior period. We rea he abnormal observaions of accouning variables in he following way; i.e., for any observaions above 99 percenile or less han percenile of each variable we assign he same value a hese 99 or percenile values by he mehod of winsorizing. 3 Panel A of Table repors Pearson correlaion numbers in he lower lef off diagonal elemens and he corresponding p-values in he upper righ off diagonal elemens. The correlaion beween ne income (NI) and comprehensive income (CI=NI+ FCT+ SEC) is and his number is slighly lower han he comparable number of for he U.S., whose resul was found by Biddle and Choi (006). Also, we noice ha he correlaion beween oher comprehensive income (OTH= FCT+ SEC) and ne income (NI) is negaive a I seems ha he larges impac for hese negaive correlaion numbers come from he correlaion beween ne income and changes in foreign currency ranslaion adjusmens wih he corresponding value of As a denominaor we also used he end of he previous period s marke value of equiy as used in Biddle and Choi (006), bu he resuls were no subsanially differen. The resuls are available upon reques from he auhors. 3 We also compued by deleing he abnormal observaions and he resuls were no remarkably differen. We used winsorizing, because in he indusry-wise analysis he number of sample observaions was crucial. 3

14 Panel B of Table repors he summary saisics of alernaive income measures and abnormal sock reurns. We find ha he mean of comprehensive income (CI) is.590 and i is higher han ha of ne income a.376. The differences in median values also look similar wih.876 and.68, respecively. However, he 5 percenile figure for comprehensive income is 0.87 and i is much lower han one for ne income of On he oher hand, 75 percenile and 95 percenile of comprehensive income are larger han hose of ne income. I suggess ha empirical disribuions of comprehensive income possess faer ails, probably more so a he upper mos righ hand side of he densiy funcion. We find ha he mean of oher comprehensive income (OTH) and ha of changes in he balance of unrealized gains and losses on securiies available-for-sale ( SEC) are posiive wih he values of 0.4, and 0.60, respecively. On he oher hand, he mean of changes in cumulaive foreign currency ranslaion adjusmens ( FCT) is negaive a The average of he cumulaive abnormal sock reurns (CAR) is.09 per cen per annum as can be seen in Panel B of Table. 3. Tesing Equaions In order o conduc ess of boh relaive informaion conen and incremenal informaion conen, we use he following esing framework. For he relaive informaion conen es we employ he Wald es proposed by Biddle e al. (995) and a sandard F-es. The former es is based on he es saisics originally consruced by Hoelling (940) for he bes model choice wih predicion crieria ha avoids he problem of no being able o esimae nuisance parameers. The original proof by Hoelling is conduced under he homoskedasic assumpion and is valid for he small 4

15 sample. Biddle e al. (995) adjused his saisics o allow for he heeroskedasiciy, uilizing Rao-Kramer lower bound covariance marix esimaors (Whie, 980). Hence, he efficiency and propery of he uniform and mos powerful es should be guaraneed for he large sample under suiable regulariy condiions (Amemiya, 985, Ch. 4). Because Wald saisics by Biddle e al. (995) are a sraighforward exension of Hoelling s original es saisics, he selecion of he bes model based on adjused R-square numbers and magniudes of he corresponding Wald saisics are isomorphic, and we can choose he bes model based on he pure comparison of adjused R-square numbers as was originally demonsraed by Hoelling (940). 4 As we will discuss below, he alernaive hypoheses of our incremenal informaion conen es are non-nesed. Boh he likelihood raio es by Vuong (989) and he J-es are known o be able o cope wih his problem, bu we decide o choose he Wald saisics proposed by Biddle e al. (995). I is because he i.i.d. assumpion, which is necessary for he Vuong es is hardly saisfied for accouning daa, and also because i is well known ha he J-es erroneously rejecs he null hypohesis when i is in fac rue (Biddle e al., 995, p. 0 and foonoe and 3), and hus resuling in serious Type I errors. 5 For he relaive informaion conen es we simply compare he performance of he model as ranked by he magniude of he adjused R-squares and es a null hypohesis of no difference in informaion conen by esing he significance of he difference in Wald saisics. 6 If we were o find ha i is significanly differen, we would be able o conclude ha an informaion variable which possesses larger adjused R-square 4 The Appendix secion of he curren paper explains he deail of his saisic. 5 We also esimaed Vuong likelihood raio ess and he resuls were no remarkably differen. 6 See our Appendix secion. 5

16 values dominaes ohers wih smaller adjused R-square values. The formal esing procedures are as follows. Firs, we es he relaive informaion conen of ne income (NI) versus our pseudo comprehensive income (CI), in which hese wo iems of oher comprehensive income are added o he ne income of each. In his case alernaive models are non-nesed, and his can be described as a sysem of equaions as in a following equaion (). In his sysem of equaions he dependen variable is he cumulaive abnormal reurn, CAR compued from he sandard uncondiional Fama and French hree facor model. Noe ha he variable wih one-lag comes ino he regression equaion because we assume ha an informaional signal is consruced as a surprise componen of he accouning variable as in Biddle e al. (995). Furhermore, we assume he AR () process for accouning numbers for Japanese daa. 7 Noe Biddle e al. (995) demonsrae ha in his case he relaionship E( β ) = φe( β) holds wherein φ denoes he AR () coefficien for ime series of he accouning numbers. Thus, as long as he coefficienφ is posiive, which is likely he case for majoriy of he firms, he signs of β and β should be opposie each oher. 8 Noe ha all he original variables are denominaed by he book value of he oal asses a he beginning of he period hrough ou our analysis. CAR CAR = α + β NI = α + β CI + β NI + β CI + ε, + ε. () As we indicaed above, in equaion () he wo equaions are non-nesed. Hence, in esing he relaive informaion conen, we need o es a hypohesis ha indicaes he 7 Kuboa e al. (005) invesigae ime series properies of ne income, accruals, and cash flow for Japanese daa of a similar sampling period and repor ha he AR() process model dominaes a random walk model for he earnings series denominaed by oal asses. 8 Kuboa e al. (005) show i is indeed he case for Japanese firms. 6

17 wo models are no significanly differen by paricular Wald saisics as proposed by Biddle e al. (995). 9 Thus, he sequenial F-ess sar from he full informaion equaion (). CAR = α + βni + β NI + β 3CI + β 4CI + ε, () Then, he sequenial residual differences beween he full informaion equaion and he missing equaion are compued from he simulaneous esimaion of he sysem of he equaions. The hypohesis can hen be esed by imposing he quadraic consrains while esimaing he maximum likelihood funcions. 0 Wih his esimaion process, he necessary Wald saisics are compued and he incremenal informaion conen es can be conduced (Biddle e al. 995). Second, as for he incremenal informaion conen es, we use a sandard analysis of variance es which is nohing bu a sandard F-es because in his case he models are nesed. For example, he full model is depiced as in a following equaion (3), and for each run one variable and also he one-lagged variable of he same variable are deleed from he original esimaing equaion a each sage, and he analysis of he variance are conduced using he F-es. We also use Whie s correcions o compue he variances in hese esimaions. For he full equaion case, we have hree variables, NI, SEC, FCT and he lagged values of hose as independen variables and he dependen variable is he abnormal reurn, CAR as follows. 9 Biddle, Seow, and Siegel (995) derive his saisic and show hey are exac under he homoskedasic and uncorrelaed case and also can be exended o he heeroskedasic case. 0 As originally demonsraed by Hoelling (940), he weighed averages of he predicion residual errors and he esimaion residual errors are compued so ha he unknown parameers cancel ou each oher. The exended mehod under he heeroskedasiciy assumpions was derived by Biddle e al. (995, equaion 3), which we use for our ess. 7

18 CAR = α + β NI + β NI + β SEC + β SEC 3 + β FCT + β FCT ε (3) Given hese base line regression equaion we es boh he relaive informaion conen and he incremenal informaion conen of ne income, oher comprehensive income, and comprehensive income as below. 4. Informaion Conen Tess 4.. Resuls from he Relaive Informaion Conen Tes In his subsecion, we firs repor he resul from he following regressions of he form (4). Since we have seven candidaes for a firm s accouning income measure, NI, CI, NI+ FCT, NI+ SEC, OTH, FCT and SEC, we run 7 differen combinaions of regressions of he following form. CAR = a + b + b [ NI + Added Componen(s) ] [ NI + Added Componen(s) ] + ε (4) Table abou here Table 3 abou here Table repors he regression coefficiens which we obain by conducing he regression analysis of he form in (4). I is no surprising ha he adjused R-squared Alhough he ess of solely OTH, FCT, or SEC are no of our direc ineres, we are showing he resul in he able jus for confirming purposes of he naure of hese variables. 8

19 are low because our dependen variable, he annualized Jensen s alpha, is esimaed based on he Fama-French 3 facor model afer all he risk facors have been conrolled for. Table 3 shows he resuls of he Wald es. In Table 3, he numbers in he lower riangular marix are Wald saisics and heir corresponding p-values are repored in he upper riangular marix. The mos imporan finding from Tables and 3 is ha ne income (NI) provides significanly greaer relaive informaion conen han comprehensive income (CI). As we can see from Table, he ne income is he second bes wih he R-square value a 0.0. Alhough he hird bes one is comprehensive income (CI), he adjused R-square value decreases o The Wald saisics beween NI and CI is and i is significan a he 5% level whose corresponding p-value is Ne income plus changes in cumulaive foreign currency ranslaion adjusmens, NI+ FCT, aains he highes adjused R-square value wih 0.03 for our pooled sample. However, in he relaive informaion conen i is indifferen o NI. The Wald saisic beween NI and NI+ FCT is.046 and is corresponding p-value is and no significan. The fourh bes measure is NI+ SEC. Thus our Wald es resuls repored in Table 3 sugges ha is relaive informaion conen is significanly smaller han ha of NI, and is indifferen o ha of CI. In he previous Table we also find ha he coefficiens for he comprehensive income variables, NI, CI, NI+ FCT, and NI+ SEC, show conemporaneously posiive signs and negaive signs wih he firs lag. In his respec we can inerpre ha he marke paricipans in TSE inerpre he unanicipaed increase in ne income and/or Naurally, he R-square values become larger for he raw reurn case wihou risk adjusmens, bu as we choose he surprise componen of accouning numbers o find associaion wih abnormal reurns, we do no repor he resul for raw reurn case. The resuls are available upon reques from he auhors. 9

20 comprehensive income as a posiive signal for he firm. To sum up he resuls of he relaive informaion conen ess, we find ha ne income is no indisinguishably informaive from pseudo comprehensive income alernaives. However, i is ye o conclude ha oher comprehensive income iems are no very informaive. We will have o furher invesigae he exisence of incremenal informaion conen of hese iems before we conclude abou he informaion conen conained in comprehensive income and oher comprehensive income numbers. We will do his in he nex sub-secion using he incremenal informaion conen es. 4.. Resuls from he Incremenal Informaion Conen Tes In his sub-secion we repor he resul from he incremenal informaion conen es. By saring from he full equaion (3), we delee one variable each ime along wih he lagged variable of he same variable and conduc he analysis of variance es. Table 4 abou here Table 4 repors he resuls from he incremenal informaion conen es. In he columns from he umos lef we repor he esimaed coefficiens of he regression equaion (4) above, he corresponding p-values, he adjused R-squares, F-values, and he corresponding p-values from he analysis of he variance es. Each row shows in he able shows he differen model specificaion where he blanks mean he se of he variable are no included. From he F-values in he second row we find ha he incremenal informaion conen of FCT is significan a he 0% level wih he p-value 0.057, and from he 0

21 hird row ha for SEC is significan a he 5% level wih he p-value The resuls suppor ha oher comprehensive income iems have incremenal informaion conens. Noe, however, ha he regression coefficiens for SEC are negaive wihou excepions and hose for FCT are also negaive excep for wo cases. These resuls are puzzling o us because i means ha he unanicipaed increase in oher comprehensive income is regarded as bad news in he sock marke. In he nex secion, we invesigae how and o which direcion he informaion conen conained in oher comprehensive income is impounded ino sock prices by focusing on he differences of firms characerisics and ry o invesigae ino his negaive-sign puzzle, before we conclude wheher hose oher comprehensive income iems ough o be disclosed as separae iems in addiion o he ne income when comprehensive income disclosure is required in Japan wih he fuure convergence o Inernaional Accouning Sandards. 5. Furher Invesigaion ino Oher Comprehensive Income Iems 5.. Negaive Signs and Firm Characerisics Even hough we confirmed he exisence of incremenal informaion conen of foreign currency ranslaion adjusmens and one of unrealized gains and losses from securiies available-for-sale in he previous secion, we also find ha regression coefficiens are negaive in some cases, and ha our informaion conen es produced resuls which are conrary o our prior conenions. Noe, however, ha he finding ha he coefficiens for changes in cumulaive foreign currency ranslaion adjusmens become negaive incidenally coincides wih he recen finding for U.S. daa by Louis (003) and i is also in accordance wih anoher empirical resul found in Japanese daa,

22 for example, by Wakabayashi (005). On he oher hand, i is opposie o he finding for U.S. daa by Pino (005) and for Canadian daa by Kanagarenam e al. (005). To furher invesigae how informaion conen conained in oher comprehensive income iems is impounded ino sock prices, while paying paricular aenions o he signs of he coefficiens, we furher divide our oal sample based on firms characerisics and ry o invesigae furher his phenomenon. For his purpose, we define wo new variables ha can purporedly represen firms characerisics of our ineress: i.e., proporions of foreign sales and a raio of available-for-sale securiies o equiy. We consruc a new variable, he proporions of foreign sales, wih he raio of sales in foreign counries o he oal sales, which purporedly measure he degrees o which he firms sale are dependen abroad. This variable highlighs he informaional role of foreign currency ranslaion adjusmens. Noe foreign sales aciviy or foreign invesmen is considered o be a risky business, and i is also subjec o poliical risk (Desai e al., 006) while i is also he source of enlarged profi. For each fiscal year from 00 hrough 004 we divide our oal sample ino 6 caegories based on he magniude of he value of his raio, which we label hereafer as FDS. In Japan, when he proporion of foreign sales is less han 0%, i is no required o disclose his number even in he noe secions of consolidaed financial saemens. Thus, he firms wih zero or less han 0% of his raio are separaely classified as one group and denoed as FDS0. The firms wih hese values larger han 0% are furher divided ino quiniles. The firms wih he highes quinile are denoed, for example, as FDS5, he nex highes as FDS4, and so forh. Anoher variable of our ineres, he available-for-sale securiies o equiy raio

23 denoed as WSEC hereafer, is defined as he raio of he amoun of available-for-sale securiies, repored a fair value o he sockholders equiy afer subracing he amoun of he available-for-sale securiies. This raio can purporedly reveal he informaional role of he imporance of unrealized gains and losses on securiies available-for-sale variable in firms operaions. Again, for all fiscal years from 00 hrough 004 we divide he sample ino five groups based on he magniudes of he value of his raio, which we label WSEC. The lowes quinile firms are classified as WSEC, he second lowes quinile firms are classified as WSEC, and so forh. Wih he above classificaion schemes we ry o resolve he aforemenioned negaive sign phenomenon of he foreign currency ranslaion adjusmen variable and he raio of available-for-sale securiies o equiy variable. We apply incremenal informaion conen ess o each subgroup of FDS0 o FDS5 and o he subgroups of WSEC o WSEC5. Table 5 repors he summary resuls only for he FDS0 group, FDS5 group, WSEC group, and WSEC5 group, respecively. Table 5 abou here We find ha, from he upper panel of Table 5, he esimaed regression coefficien for FCT for he FDS0 group, he mos domesic firms, is srongly negaive a even hough i is no significan (p-value 0.08), as can be seen in he umos righ column as p-value For his group he informaion on he foreign currency ranslaion adjusmens does no seem o maer much and he sign condiions are he same wih our overall sample resul. On he oher hand, he regression coefficien for FCT for he FDS5 group, he group of he mos foreign oriened firms, is 3

24 significanly posiive a ( p-value 0.0). I is a new finding and we have successfully solved one case of he apparen puzzle of he negaive coefficiens for foreign currency ranslaion adjusmens by uilizing such a sub-caegorizing procedure based on he proporions of foreign sales variables. Thus, we conclude ha only for he subse of he firms wih he highes degree of foreign dependency, he unanicipaed increase in foreign currency ranslaion adjusmens is regarded as good news in he sock marke, and in his case ha he informaion possesses incremenal informaion conen. 3 Nex, we compare WSEC and WSEC5 as classified by he magniudes of he raio of available-for-sale securiies o equiy. Alhough here does no exis any previous sudy which has found negaive signs for his variable, we ry o invesigae his negaive sign phenomenon from he viewpoin of cross-share holdings known o be prevalen among Japanese firms and o characerize he governance srucure of Japanese companies. 4 In he lower panel of Table 5 we find ha he esimaed regression coefficien for 3 Alhough we do no repor i here, coefficiens became posiive only for his subgroup. The resuls are available upon reques from he auhors. Noe ha boh Louis (003) and Pino (005) used samples of U.S. mulinaionals and reached conflicing conclusions. The srucure of mulinaionals migh be differen beween U.S. firms and Japanese firms. I is also observed ha he majoriy of larges mulinaional firms in he world are European firms as is poined ou by Doupnik and Perera (007). The characerisics of Japanese mulinaionals firms are, according o he observaion by he curren auhors, in imporing raw maerials, manufacuring pars or produc abroad, and selling goods and services o boh foreign counries and Japan. Hence, i can be poined ou ha foreign subsidiaries of Japanese mulinaionals are conducing boh on he demand side and he supply side of he business operaions. 4 The observaions of he cross-share holding phenomenon among Japanese firms are no new (McDonald, 989), and as a resul McDonald argues ha he P/E raios end o be inflaed. Because, we use reurn daa we are free from his bias. More imporanly, recenly he inerpreaions of he economic consequences of cross-share holding are mixed. USing Japanese daa in he 980s Lichenberg and Pusher (994) claim ha high levels of iner-corporae shareholding hinder firms performance and insulae hem from heir own problems leading o moral hazard problems. However, hey also argue ha he equiy holding by financial insiuions can induce sronger monioring and promoe produciviy. Chung e al. (004) also recenly find ha for he cross-held firms he degree of value relevance is lower and infer ha cross business holdings aggravaes unneling or managerial opporunism hrough discreionary accouning choices. 4

25 SEC for WSEC, he group of firms wih he smalles raios, is significanly posiive a 0.9 (p-value a 0.040), and he coefficien for SEC for WSEC5, he group of firms wih he larges raios, is negaive a -0.49, bu no significan ( p-value a 0.386). This resul suggess ha he informaion on he unrealized gains and losses on securiies available-for-sale is regarded as eiher good or bad news in he sock marke, depending on magniudes of he raio of he available-for-sale securiies o equiy. Because socks classified as securiies available-for-sale iems are generally held for he purpose of he firms capial alignmen and also for he purpose of cross-share holdings among Japanese firms, we hypohesize ha he firms wih higher raios of available-for-sale securiies o equiy are subjec o inefficien capial use. In paricular, firms wih he highes available-for-sale securiies o equiy raio are considered o be he firms which are under severe capial alignmen problems, mos ypically in close connecions wih financial insiuions, and hey may also face difficulies in selling hose socks even if hey wan o do so. As o shareholdings among Japanese firms, Ang and Consand (00) classify hree ypes of invesors in Japan. The firs ype is he governmen or is agencies, he second ype, srongly supporive shareholders, and he hird ype is unrelaed invesor groups. Our sample wih he higher degree of available-for-sale securiies o equiy raio would fi o his second ype. Accordingly, we claim ha he main reason why he regression coefficien for SEC of he WSEC5 group becomes negaive can be inerpreed as evidence ha invesors inerpre he unanicipaed increase in he value of available-for-sale securiies as bad news. This can happen when firms are forced o cross-hold securiies agains heir will, and hus invesors also judge hese firms as under he inefficien use of he capial. 5

26 Alhough we do no repor in a separae able, from he resul of he incremenal informaion conen es full equaion, we repor ha for smaller firms (LnMV) wih high raios of available-for-sale securiies o equiy (WSEC3) he coefficien for available-for-sale securiies o equiy (SEC) is negaive a -.3, significan wih p-value of 0.03, while for larger firms wih low raios, he coefficien is posiive a wih a p-value of 0.6. Hence, we find ha he adverse effec of being forced o hold sock is more severe for smaller sized firms. However, we furher conjecure ha, if hese firms were proeced as complee subsidiaries by heir paren firms, he sory migh be differen. For his purpose, we again repor he regression coefficiens of he full equaion from he incremenal informaion conen es, for which he sample is classified ino firms wih and wihou paren firms. 5 For firms wih paren firms i is wih a p-value of Even hough i is sill negaive, i is no significan. On he oher hand, for firms wihou paren firms he coefficien is -.58 wih a p-value a 0.0. So, for firms wihou paren firms, he unrealized gain is a bad signal. We claim ha he recognized gains and losses of securiies available-for-sale which are mainly held by proecing paren firms is neiher good nor bad news, while in case of loosely cross-held business associae groups i is bad news. We conclude ha he negaive sign of changes in available-for-sale securiies is no a puzzle, and indeed, he evidence of bad corporae governance for smaller firms and firms who are forced o cross-hold shares, while no proeced by heir paren firms. Overall, we claim ha hese bad signals for hese wo iems of he oher comprehensive income ough o be disclosed for he benefi of invesors as we 5 Noe ha he Japanese consolidaion sandard is he same above 50 per cen crieria for subsidiaries along wih he res of he world. 6

27 discussed in previous Secion Furher Analysis ino Indusries In his final subsecion we furher spli our sample ino each indusry based on 33 official classificaions by he Tokyo Sock Exchange and es he robusness and sabiliy of our esimaed coefficiens. In an iniial sage of his inquiry, we found ha for he cases in which he oal firm-years are less han 00, boh coefficiens and saisics vary drasically across indusries and some of he resuls become dramaically differen from he overall sample resul. 7 Hence, we decide o repor only he indusry-wise resul for he four indusries in which he oal firm-years are more han We also exclude financial firms as menioned before. Table 6 abou here Table 6 repors he resul of he relaive informaion conen es for fifeen indusries, in which he number of observaions exceeds 00. We only repor he cases where each of wo oher comprehensive income iems is incremenally added o he ne income number. 9 The firs column repors he number of observaions, he second column, he foreign dependency rae, he hird column, he weigh of he securiies-for-sale, hen he adjused R-square values and he Wald saisics and he corresponding p-values, respecively. We find ha for hese indusries, neiher he addiion of he changes in cumulaive 6 See foonoe 9. 7 Biddle e al. (995) also show heir resuls for he U.S. vary from indusry o indusry especially for indusries wih smaller number of observaions. 8 The deailed resuls on all indusries are available upon reques from he auhors. 9 The complee indusry-wise resuls are again available upon reques from he auhors. 7

28 foreign currency ranslaion adjusmens, nor he addiion of he changes in he balance of he unrealized gains and losses on securiies available-for-sale can significanly increase he incremenal informaion conen as far as we judge from he p-values from he Wald es. Wih hese indusry-wise resuls, hus we conclude ha ne income, insead of comprehensive income, may be he number o be repored for hose represenaive indusries in Japan. However, as we discussed in he previous sub-secion along wih Table 5, for he subse of firms wih he highes foreign dependency rae, he changes in cumulaive foreign currency ranslaion adjusmens possess he significan incremenal informaion conen a he 5% significance level. Hence, for some firms, we infer ha i will be worhwhile o disclose comprehensive income informaion, using he changes in cumulaive foreign currency ranslaion adjusmen. Noe in Table 6 ha Elecric Appliances, Transporaion Equipmen, and Machinery show he highes proporions of foreign sales, and Wholesale Trade, Texile and Apparels, Consrucion, and Transporaion Equipmen show he highes raios of he share held by hese firms in he able. In Table 7 and Table 8 we find ha here exis some sysemaic paerns of signs and magniude of regression coefficiens are associaed wih he magniude of hese wo variables. Table 7 abou here Table 8 abou here In Table 7 we find ha he higher proporion of foreign sales is associaed wih higher posiive coefficiens of conemporaneous changes in foreign currency 8

29 ranslaion adjusmen. On he oher hand, in Table 8 we find ha he higher raio of he share held is associaed wih he higher absolue value of he negaive coefficiens of he changes in unrealized gains and losses for securiies available-for-sale. These confirm our aforemenioned poins discussed in he previous sub-secion. Moreover, in Table 7 and 8 we also repor he resul of he incremenal informaion es of he changes in cumulaive foreign currency ranslaion adjusmen and he changes in he balance of unrealized gains and losses on securiies available-for-sale in he upper mos righ hand hree columns. We repor only he regression coefficiens of hese iems along wih one lag, when he full equaion (3) is esimaed, and hen he F-values whenever his paricular variable of ineres is dropped from his full equaion are repored in he second umos column. In Table 7 we find ha he p-values for he incremenal es are no significan for all he cases excep Machinery a he 5% significance level a Also, all he coefficiens wih and wihou lag are no significan a he 5% level. We find ha, for 0 ou of 5 indusries, he conemporary coefficiens for he changes in cumulaive foreign currency ranslaion adjusmen are posiive. The evidence augmens he earlier overall resul in Table 4 where he incremenal informaion conen of his variable was weakly significan wih he p-value when dropped from he full equaion. Thus, he evidence suppors he view ha disclosing he changes in cumulaive foreign currency ranslaion adjusmen will be useful for some indusries in he sense of incremenal informaion. In Table 8 we find ha he p-values for he incremenal es are no significan for all cases excep Land Transporaion, a a 0% significance level a Almos all he coefficiens wih and wihou lag are no significan a he 5% level excep Land 9

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