financial accounting in brazil: an empirical examination

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This article was downloaded by: [Umeå University Library] On: 24 November 2014, At: 04:17 Publisher: Routledge Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK Latin American Business Review Publication details, including instructions for authors and subscription information: http://www.tandfonline.com/loi/wlab20 Financial Accounting in Brazil: An Empirical Examination Alexsandro Broedel Lopes PhD a a Universidade de São Paulo , Brazil E-mail: Published online: 17 Oct 2008. To cite this article: Alexsandro Broedel Lopes PhD (2006) Financial Accounting in Brazil: An Empirical Examination, Latin American Business Review, 6:4, 45-68 To link to this article: http://dx.doi.org/10.1300/J140v06n04_03 PLEASE SCROLL DOWN FOR ARTICLE Taylor & Francis makes every effort to ensure the accuracy of all the information (the “Content”) contained in the publications on our platform. However, Taylor & Francis, our agents, and our licensors make no representations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose of the Content. Any opinions and views expressed in this publication are the opinions and views of the authors, and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content should not be relied upon and should be independently verified with primary sources of information. Taylor and Francis shall not be liable for any losses, actions, claims, proceedings, demands, costs, expenses, damages, and other liabilities whatsoever or howsoever caused arising directly or indirectly in connection with, in relation to or arising out of the use of the Content. This article may be used for research, teaching, and private study purposes. Any substantial or systematic reproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in any form to anyone is expressly forbidden. Terms & Conditions of access and use can be found at http:// www.tandfonline.com/page/terms-and-conditions

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Page 1: Financial Accounting in Brazil: An Empirical Examination

This article was downloaded by: [Umeå University Library]On: 24 November 2014, At: 04:17Publisher: RoutledgeInforma Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House,37-41 Mortimer Street, London W1T 3JH, UK

Latin American Business ReviewPublication details, including instructions for authors and subscription information:http://www.tandfonline.com/loi/wlab20

Financial Accounting in Brazil: An EmpiricalExaminationAlexsandro Broedel Lopes PhD aa Universidade de São Paulo , Brazil E-mail:Published online: 17 Oct 2008.

To cite this article: Alexsandro Broedel Lopes PhD (2006) Financial Accounting in Brazil: An Empirical Examination, LatinAmerican Business Review, 6:4, 45-68

To link to this article: http://dx.doi.org/10.1300/J140v06n04_03

PLEASE SCROLL DOWN FOR ARTICLE

Taylor & Francis makes every effort to ensure the accuracy of all the information (the “Content”) containedin the publications on our platform. However, Taylor & Francis, our agents, and our licensors make norepresentations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose of theContent. Any opinions and views expressed in this publication are the opinions and views of the authors, andare not the views of or endorsed by Taylor & Francis. The accuracy of the Content should not be relied upon andshould be independently verified with primary sources of information. Taylor and Francis shall not be liable forany losses, actions, claims, proceedings, demands, costs, expenses, damages, and other liabilities whatsoeveror howsoever caused arising directly or indirectly in connection with, in relation to or arising out of the use ofthe Content.

This article may be used for research, teaching, and private study purposes. Any substantial or systematicreproduction, redistribution, reselling, loan, sub-licensing, systematic supply, or distribution in anyform to anyone is expressly forbidden. Terms & Conditions of access and use can be found at http://www.tandfonline.com/page/terms-and-conditions

Page 2: Financial Accounting in Brazil: An Empirical Examination

Financial Accounting in Brazil:An Empirical Examination

Alexsandro Broedel Lopes

ABSTRACT. In this study, evidence of the value relevance of Brazilianaccounting numbers over the periods 1995-1999 is presented. Brazil is adeveloping code law country, wherein Brazilian firms are financed by an“insider model,” i.e., they do not rely on capital markets and publiccredit markets to finance their operations. Brazil complies with four outof the five criteria that Ali and Hwang (2000) show to be negativelyrelated to the relevance of financial accounting information. Based onthis scenario, public financial accounting information is not expected tobe value relevant in Brazil. Therefore, results show that, in terms oflevels regression (prices as dependent variables), accounting seems to bereasonably value relevant (using R2 as a measure of value relevance).However, after controlling for scale effects, as suggested by Brown et al.(1999), the R2 is significantly reduced. In addition, the earnings-returnrelationship and the conservatism of earnings are examined. As previousresearch suggests (Leuz and Wustemann, 2003), the earnings-returnrelationship is weak in Brazil as well as the conservatism of earnings asexpected, given previous research comparing code and common lawcountries (Ball et al., 2001). The results of the study also show that bookvalues concentrate most of the value relevance on preferred shares.

Alexsandro Broedel Lopes is Assistant Professor at the Universidade de São Paulo,Brazil and a PhD student at the University of Manchester (E-mail: [email protected]).

The author would like to thank Nelson Carvalho, Martin Walker and seminar partic-ipants at LSE, Manchester, FGV, USP and Fucape for their suggestions. The authorwould also like to thank FIPECAFI, FUCAPE and CNPQ for financial support.

Latin American Business Review, Vol. 6(4) 2005http://www.haworthpress.com/web/LABR

© 2005 by The Haworth Press, Inc. All rights reserved.doi:10.1300/J140v06n04_03 45

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46 LATIN AMERICAN BUSINESS REVIEW

RESUMEN. Este estudio presenta pruebas de la importancia que lascifras de la contabilidad brasileña tuvieron en el período 1995-1999.Brasil es un país que utiliza un código jurídico en desarrollo gracias alcual las empresas brasileñas reciben financiamentos de un “modelointerno.”Ej.: ellos no dependen de los mercados de capital ni los mercados de cré-dito público para financiar sus operaciones. Brasil cumple cuatro de loscinco criterios que Ali y Hwang (2000) muestran que están negativamentevinculados a la importancia de la contabilización de la información fin-anciera. En base a este escenario, no se espera que la información contablepúblico financiera tenga un valor importante en Brasil. Por consiguiente,los resultados muestran que, en términos de niveles de regresión (precioscomo variables dependientes), la contabilidad parece tener un valorrazonablemente importante (usando R2 como una medida de la imp-ortancia del valor). Sin embargo, después de controlar los efectos deescala como fue sugerido por Brown et al. (1999), R2 se reduce signi-ficativamente. Además también se examina la relación ganancia-retornosasí como el conservadorismo de las ganancias. Tal cual sugirieron anter-iormente otros investigadores (Leuz y Wustemann, 2003), la relación en-tre ganancia-retornos es una relación débil en Brasil así como era deesperar que lo fuese el conservadorismo de las ganancias, debido a lasinvestigaciones anteriores que compararon el código y los países de la leyconsuetudinaria (Ball et al., 2001). Los resultados de este estudiomuestran que el valor contable se concentra en los valores relevantes deuna acción preferencial.RESUMO. Neste estudo, apresentamos os indícios da relevância do va-lor dos números contábeis brasileiros durante o período de 1995-1999. OBrasil é um país onde o direito está se desenvolvendo, e onde asempresas brasileiras são financiadas por um “modelo interno,” i.e., elasnão confiam no mercado de capitais nem nos mercados de créditopúblico para financiar as suas operações. O Brasil atende a quatro doscinco critérios apresentados por Ali e Hwang (2000) como negativos emrelação à relevância da informação sobre contabilidade financeira. Combase neste cenário, a informação da contabilidade pública financeira nãoparece ter valor relevante no Brasil. Assim, os resultados comprovamque, em termos de níveis de regressão (preços como variáveis depen-dentes), a contabilidade parece ter um valor de relativa relevância(usando R2 como medida de relevância do valor). Porém, após o controlepara efeitos de escala, conforme sugere Brown et al. (1999), o R2 éconsideravelmente reduzido. Além disso, a relaçao reñtorno-ganhos e o

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conservadorismo dos ganhos sao analisados. As pesquisas anteriores(Leuz and Wustemann, 2003) indicam que a relação retorno-ganhos éfraca no Brasil, assim como o conservadorismo dos ganhos, segundopesquisas prévias comparando países com códigos e direito consuet-udinários (Ball et al., 2001). Os resultados deste estudo mostram tambémque o valor contábil concentra a maior parte do valor de relevância dasações preferenciais. [Article copies available for a fee from The HaworthDocument Delivery Service: 1-800-HAWORTH. E-mail address: <[email protected]> Website: <http://www.HaworthPress.com> © 2005 by TheHaworth Press, Inc. All rights reserved.]

KEYWORDS. Emerging markets, information asymmetry, value rele-vance, asymmetric recognition

INTRODUCTION

Country-specific aspects have started to be incorporated into capitalmarkets-based financial accounting research recently. These studies areperformed to investigate if country-specific factors can influence thevalue relevance of accounting information. The use of international evi-dence is justified, because most of the research in this area has been con-ducted in the U.S.; however, the generalization of the evidence obtainedwith U.S. data can lead to errors since the economic and social environ-ments change significantly across countries. One of the aims of this lineof research is to investigate whether the relationship between account-ing numbers and market variables (prices and returns) observed in theU.S. can be extended to other countries, and which factors cause the ex-isting differences, if they do in fact exist. This paper presents evidenceon the value relevance of accounting figures to explain market variablesin Brazil. The motivation to perform the present study was twofold.First, there appears to be no reported evidence in the international ac-counting literature on the relationship between accounting informationand market variables in Brazil. In addition, Brazil is a relevant emergingmarket with an active accounting profession, and publication of finan-cial statements is mandatory for all listed firms. Second, the country-specific factors in Brazil provide an interesting opportunity to test theexisting theories that so far have only been studied in developed coun-tries. The study’s results will contribute to the literature by addingevidence on the relation between accounting figures and market-basedvariables in an international context.

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Evidence shows that Brazil complies with four of the five criteria thatAli and Hwang (2000) show to be related to the irrelevance of account-ing data. First, Brazil has a bank-oriented (as opposed to a market-ori-ented) financial system. In Brazil, a small number of banks supply mostof the capital that firms need, and as a consequence, there is a lowerdemand for published financial reports. Second, private sector bodieshave no relation whatsoever with the standard-setting process. InBrazil, all accounting rules are issued directly by the central govern-ment or by one of the agencies that have responsibility for specificguidelines. The premise here is that government standard setters issuerules that are designed to serve government needs and not to inform eq-uity investors. Third, Brazil is considered to be a Continental modelcountry, because its accounting model is strongly influenced by its Ibe-rian colonizers. Fourth, tax rules have a strong influence on Brazilian fi-nancial reporting and sometimes it is indistinguishable. The tax laws areclearly influenced by a wider range of factors than the needs of equityinvestors. Recent research by Leuz and Wustemann (2003) suggeststhat the earnings-return relationship is weak for countries that adopt a fi-nancial “insider model.” An insider model is characterized when firmsrely on special relationships and deals to obtain funding instead of usingthe public capital and credit markets. Publicly available financial ac-counting information is of no relevance in countries where this kind ofarrangement is predominant. Brazil clearly has adopted an “insidermodel.” Public markets for equity and debt in Brazil are relatively smalland are becoming even smaller. Additionally, Ball et al. (2001) showthat earnings conservatism is a function of a country’s legal regime, andthat common law countries have more conservative earnings than codelaw ones. Brazil is clearly a code law country.

Based on Brazil’s country-specific factors, the value relevance of ac-counting figures is expected to be lower in Brazil than what is com-monly reported in the literature for more developed common lawcountries (especially the U.K. and U.S.). The results herein show thataccounting figures are significant on levels regression (prices as de-pendent variables). However, most of the explanatory power is signifi-cantly reduced when the variables are controlled for scale. The variablesare deflated by beginning of the year share prices, as proposed byBrown et al. (1999). In addition, as expected, the earnings-returns rela-tionship is very weak and the conservatism (asymmetric recognition) ofearnings is also not economically significant, despite being statisticallysignificant. In both specifications the explanatory power is very low.Overall, these results confirm the stated hypothesis that accounting

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figures are not value-relevant to explain market variables (prices andreturns) in Brazil; in other words, the explanatory power of the regres-sions is very low when deflated by beginning of the year prices. Fur-thermore, the sample is split into common and preferred shares–anadditional study motivated by the importance that preferred shares havein Brazil. In most cases, firms only publicly issue preferred shares whilekeeping common shares (preferred shares do not have voting rights) inthe hands of the owners. The results show that value relevance is splitamong earnings and book values for common shares, and that bookvalues concentrate value relevance for preferred shares. As previousresearch suggests (Joos and Lang, 1994), accounting rules in bank-ori-ented financial systems tend to emphasize valuing balance sheet itemsto ensure that firms maintain sufficient resources to repay debt. Theresults confirm this argument. Preferred shares are closer to credit thanequity instruments, and as expected book values they are more valuerelevant.

In the second section the previous research is analysed, and in thethird section the country-specific factors related to Brazil are presented.In the fourth section the models used and the results obtained are pre-sented, and finally in the fifth section the conclusions of the study arepresented.

RELATION TO PRIOR RESEARCH

This work is directly related to some recent contributions to the inter-national capital markets-based accounting literature, which have attem-pted to investigate the impact of country-specific factors on the valuerelevance of accounting numbers. This line of research has its roots inthe recent emergence of corporate governance research. Shleifer andVishny (1997) survey this line of research and show the pervasive effectof legal and institutional aspects on the development and functioning offinancial markets. Authors in this area have focused extensively on therole played by legal protection arrangements in the organization of mar-kets (La Porta et al., 2000). They emphasize that corporate governancearrangements are mechanisms used by investors to protect themselvesagainst exploitation by majority shareholders. These arrangements dif-fer dramatically across countries. They pay special attention to the in-fluence of the enforcement of legal rights across code and common lawcountries, pointing out that when investors do not trust completely inthe law’s enforcement, they can find alternative mechanisms to protect

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themselves. Ownership concentration is the most common mechanismused by investors to protect themselves against managers in code lawcountries, where law enforcement is not as effective as in common lawcountries. In code law countries, investors are more likely to adopt“insider models”. They do not rely on published financial informationbut on close relationships to reduce information asymmetries.

Accounting authors have relied on this literature (Nobes, 1998) topropose a general model of the reasons for international differencesin accounting practices. Nobes (1998) proposes that differences inaccounting practices are determined by two explanatory factors. Forculturally self-sufficient countries he suggests that the class of the pre-dominant accounting system depends on the strength of the equity-out-sider market (Class A countries). For culturally dominated countries,the class of the accounting system is determined by cultural influences(Class B countries). However, previous corporate governance literaturehas shown that the strength of the equity-outsider depends on the legalregime adopted (common law countries are more likely to developstrong equity markets). It is possible to link the classification proposedby Nobes (1998) to the investor protection argument developed by LaPorta et al. (1997) and it is more likely that equity-outsider systems willbe found in common law-developed countries like the U.K. and U.S.Code law countries, which do not provide the same protection to inves-tors, are less likely to develop strong capital markets and are more likelyto develop bank-oriented financial systems, where firms rely more onprivate access to information. Based on this, Nobes (1998) shows someexamples of the accounting features of the two possible accountingsystems. In the next section, Brazil is classified according to the Nobesmodel.

Nobes (1998), however, does not provide any empirical evidence onthe properties of accounting numbers over these accounting systems.Ali and Hwang (2000, hereafter AH) investigate five country-specificfactors and their relation to the value relevance of accounting numbersin 16 countries. First, their results show that value relevance is lower forcountries with bank-oriented financial markets. Banks normally havespecial access to information from firms directly and do not depend onpublished financial statements. The bank-oriented financial system is afeature of Class B countries according to Nobes (1998). Leuz andWustemann (2003: p. 2) discuss this aspect in more detail for German

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firms; according to them,

Given the nature of the German financial system, which is often de-scribed as an “insider system,” we expect that information asymme-tries are primarily resolved via private information channels ratherthan public disclosure. Thus, the accounting system likely exhibitselements that support insider governance and relationship-basedcontracting. Our institutional analyses confirm these specifications.Due to the existence of private information channels, financial state-ments are less important in terms of monitoring economic perfor-mance and assume other roles, such as determining dividends.

Like AH, these authors related the value relevance of accounting in-formation to the role it performs in terms of information asymmetry re-duction. Ball et al. (2001) investigate the conservatism of accountingearnings and its relation to common versus code law countries. Theirbackground is similar to that of AH. They assume that equity marketsare more likely to emerge in common law countries and, as a conse-quence, earnings will present a timely reaction to bad news. This argu-ment is directly related to the literature on corporate governance, whichshows that investors are better protected in common law countries thanin code law countries, and accounting numbers are more likely to be di-rected to investors instead of to creditors or government authorities. Asexpected, their results show that earnings are more conservative incommon law countries than in code law ones.

AH’s second investigation shows that value relevance is lower forcountries where private-sector bodies are not involved in the standard-sector process. The premise here is that government authorities estab-lish accounting rules to attend to regulatory needs instead of to informequity investors. Again, previous research (Anderson, 1999) has sug-gested that interventionist states directly affect the contracting processin the economy by adding uncertainties over the enforcement of con-tracts and political influence. However, private-sector influence onstandard-setting is normally observed in common law countries (theBritish Accounting Standards Board and the American Financial Ac-counting Standards Board are two obvious examples). In this aspect, theinfluence of private-sector bodies on the regulation of financial ac-counting is highly correlated with the equity-outsider investor modelpresented above, which is a common feature of common law countries(Class A countries).

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The third factor AH survey is the influence of the so-called Continentalversus British-American models on the value relevance of accounting. Asexpected, the value relevance is lower for Continental model countries(Class B countries) than for British-American model countries (ClassB). This result is not surprising because British-American model (com-mon law) countries are more likely to have equity-outsider financialsystems with dispersed ownership structures.

The fourth factor AH investigate is the influence of tax rules on fi-nancial accounting measurements. They show evidence that value rele-vance is lower when tax rules significantly influence the financialreporting process. This is consistent with the assumption that tax rulesare influenced by political and economic environments rather than theneeds of equity investors. According to Nobes (1998), the influence oftax rules is greater in Class B countries, where published financial state-ments are not the primary source of information to investors.

Finally, AH show that the value relevance is higher when more isspent on external auditing. This is to be expected since external auditingis more likely to be extensively used on equity-outsider markets (ClassA countries).

Overall, this literature (AH, Nobes and La Porta et al., 1997, 2000)suggests that the value relevance of published financial accounting in-formation will be higher in common law equity-outsider oriented coun-tries (class A). However, the AH sample contains only developedcountries and there is not a single South American country in the sam-ple. This paper contributes to this literature by providing fresh evidenceon Brazil, a previously undocumented country in the international ac-counting literature. Additionally, it shows evidence on the value rele-vance of accounting information for common and preferred shares.Preferred shares are common in Brazil and reflect its contractualenvironment, as is explained in the next section.

Regarding Brazilian financial markets, Anderson (1999) provides aninteresting overview. Despite being focused on the bond market, hepresents some evidence on the functioning of financial markets as awhole in Brazil. According to him, high inflation, volatile real-sectoractivity, underdeveloped institutions, and an interventionist state char-acterize Brazil. Despite these factors, the vitality of Brazilian financialmarkets shows that firms imaginatively design financial contracts to ad-dress difficulties in the economic environment. Anderson also showsthat, as expected, the concentration of firms that present a low relianceon external financing ownership is enormous. Using data from 1991 for68 nonfinancial firms (blue chips), he shows that the top shareholder

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owns, on average, 54.9% of common shares and 33.2% of all shares.The top three shareholders hold, on average, 74% of common sharesand 49% of all shares. He also comments on three general states of Bra-zilian institutions:

Brazil’s institutions are far from primitive, but they appear insuffi-ciently developed to substantially assist parties to financial con-tracts. First, Brazil has a civil-law legal tradition, characterized . . .as an impediment to external financing in general. The Brazilianlegal system, in particular, does not imply the principle of staredecisis and the judiciary is regarded as inefficient and sometimeseven corrupt.

These observations about Brazilian financial markets show the pecu-liarities of this emerging market. The next section discusses in moredetail the country specific factors related to the value relevance of finan-cial accounting in Brazil.

COUNTRY-SPECIFIC FACTORS RELATEDTO FINANCIAL REPORTING IN BRAZIL AND HYPOTHESIS

DEVELOPMENT

The Brazilian accounting environment is presented in this section ac-cording to AH’s country-specific factors and Nobes’ (1998) systemsclassifications. The factors discussed by AH are presented together withadditional evidence on special features of the Brazilian scenario, whereappropriate.

Bank Oriented-Financial System and Ownership Concentration

Studard (2000: 15) comments,

Since the 1950’s, the financing of economic development in Brazilhas relied significantly on selective credit policies, inflationary fi-nancing and external saving. We claim that in the 1990’s and forthe first time in its post-war history, due to the developments bothin the international and in the domestic financial markets, there ex-isted opportunities to develop non-inflationary private sources oflong term finance and to reduce its dependency on foreign savings.

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These opportunities have been so far spared due to the lack of poli-cies towards enhancing some of the positive aspects of recent de-velopments in Brazil’s financial systems, and avoiding excessivevolatility and instability of financial markets.

Brazilian firms clearly do not depend on equity markets to financetheir activities. Comparing Brazil with the U.S. in Table 2 of La Portaet al. (1997: 1138), this is clearly observed. Brazil has a ratio of externalcapitalization to GNP1 of 0.18, while this ratio is 0.58 in the U.S. The ra-tio of the number of domestic firms listed in a given country to its popu-lation in millions in 1994 is 3.48 in Brazil and 30.11 in the U.S. Duringthe period 1986-1996, there was not a single IPO in Brazil; but exactlythe opposite occurred later, for in 2000, seven public companies turnedprivate: Agrale, White Martins, Arno, Durex Industrial, Abril, Ceval,and Lojas Brasileiras. This movement is characteristic of the poor pro-tection that investors have in Brazil. According to Luz (2000), Brazilianmajority shareholders have been exploiting minority shareholders inseveral ways, including the sale of assets below market value to compa-nies that are owned by directors of the parent company, the employmentof unqualified personnel, the implementation of projects to benefit com-pany executives, and the classic problem of high salaries. Nowadays,there is a project in Brazil’s Congress to modify corporate law to allowfor better treatment for minority shareholders. This aspect of Braziliangovernance has a direct impact on ownership concentration. Researchon corporate governance has shown that ownership concentrationworks as a substitute for poor investor protection (Sheleifer and Vishny,1997) (the situation could not be worse in Brazil). According toEconomatica (in Gazeta Mercantil, 2000), in most companies that onlypossess voting shares, 70% of the shares are in the hands of just oneshareholder. According to Mackinsey (2000), 95% of all companiestraded on the Sao Paulo Stock Exchange (BOVESPA) have 3 or lessshareholders with 50% or more of the voting rights. Based on this evi-dence, it may be concluded that Brazil is, beyond any doubt, a countrywith a bank-oriented financial system coupled with poor investor pro-tection, which leads to enormous ownership concentration in the capitalmarkets. In addition, firms in Brazil can issue preferred and commonshares. Preferred shares do not command voting rights and their ownersonly have access to dividends. In the case that dividends are not paid forthree consecutive years, preferred shares acquire voting rights, but theydo not become common shares. Firms can issue a maximum of 2/3 oftheir total shares as preferred shares. Preferred shares are considered a

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sign of bad governance in Brazil, and recently the Sao Paulo Stock Ex-change established a classification of firms based on their governance.To attain higher levels of governance, firms must exchange all theirpreferred shares for common shares. These aspects contribute to reducethe value relevance of published financial accounting information.According to Nobes (1998), Brazil can be classified, based on the aboveevidence, as a Class B country, because it clearly does not have anequity-outsider market model.

Government Standard Setting

Brazil’s corporate law (Lei das Sociedades por Aões, Lei 6404 de1976) is the most important accounting normative for firms listed on theSao Paulo Stock Exchange (BOVESPA). In addition to this corporatelaw, the Brazilian Securities and Exchange Commission (CVM) issuesnorms that regulate specific accounting matters. While CVM statementsare considered to be GAAP in Brazil, they cannot be in disagreement withwhat is set forth in the law. Financial institutions are regulated directly bythe Central Bank of Brazil, which has the power to issue accounting state-ments related to financial institutions. In addition to corporate law and theCVM, Brazilian firms have to comply with specific accounting guide-lines provided by the tax authority (SRF). Insurance and pension institu-tions have their own regulators (SUSEP and SPC). Despite this structure,the Ministry of Finance sometimes simply intervenes in accounting mat-ters. In 1997, the government authorized firms to defer losses on ex-change rate devaluations. This deferment was not possible under theCVM instructions. Professional accounting bodies have no influence onthe standard-setting process in Brazil. Thus, Brazil clearly is a Class Bcountry in this matter. As discussed by AH, this aspect is likely to reducethe value relevance of published accounting numbers in Brazil.

Continental Model

Nobes (1998) discusses the concept of culturally self-sufficient andculturally dominated countries. As is the case all over South America(former Spanish and Portuguese colonies), Brazil is culturally depend-ent on and clearly adopts a Continental model. As Anderson (1999)comments:

. . . the quality of disclosure by Brazilian firms is perceived to below. South American accounting practices are dominated by the

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legal and administrative systems inherited from the Iberian colo-nizers and the ‘highly political environment that results from suchsystems.

Teixeira da Costa (1993)–first president of the CVM–comments thatBrazilian annual reports are not really prepared to inform investors but tocomply with regulations (Class B country). Based on AH’s evidence, thisaspect is likely to reduce the value relevance of Brazilian accountingnumbers.

Influence of Tax Rules on Financial Reporting

Tax legislation in Brazil strongly influences financial reporting. InBrazil, firms can present financial statements under accounting meth-ods not allowed by the tax authority (SRF). These firms must adjusttheir statements to form the basis for the calculations in a special book(LALUR) designed to conciliate the SRF and companies’ legal regula-tions. However, tax rules have a major influence since most firmschoose to report according to them, thereby avoiding costly adjustmentson LALUR. Such is also the case with inventory methods. Most compa-nies adopt FIFO due to tax limitations on reporting LIFO, for example.In this aspect, Brazil is clearly a Class B country.

Relevance of Auditing

Data about the amount spent on external auditing is not available forBrazilian firms.

Other Aspects

Nobes (1998, p. 168) gives some examples of features of the accountingsystems for Class A and Class B countries. In addition to the aforemen-tioned aspects, Brazil presents additional similarities to the Class B coun-try category. Initially, accounting practices follow tax rules regardingprovisions for depreciation. Unsettled currency gains have been deferredand the law requires legal reserves. Cash flow statements are not requiredand revaluation of assets is allowed. Finally, firms can capitalize researchand development expenses and an amortization period can be extendedup to 10 years.

Overall, taking together all the aspects described in this section, ac-counting is expected to be of low value relevance in Brazil.

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MODELS AND RESULTS

Models

According to the previous section, Brazil has four of the five majorcriteria for accounting irrelevance, as proposed by Ali and Hwang(2000). Additionally, Brazil has a code law tradition coupled with a cap-ital market where firms have a strong concentration of ownership; and,basically, not a single company is really public. In addition, accountingrules allow managers a high degree of discretion.

Presently, the hypothesis is raised that earnings’ relevance as infor-mation asymmetry reducers in Brasil will be reduced given the level ofdevelopment of capital markets and the current state of the profession inthe country. In addition, book values are expected to present greatervalue relevance than earnings due to book values’ role in the Braziliangovernance structure. There are three competing explanations for therole played by equity book value in valuing firms. First, it can be a con-trol for scale difference (Barth and Kallapur, 1996). Second, it can be aproxy for expected future abnormal earnings (Ohlson, 1995). Third, itcan be a proxy for a firm’s abandonment option (Berger et al., 1996).Book values are expected to be relevant as proxies for liquidation valuein Brazil. This aspect, however, will not be directly tested since anotherproxy for liquidation value in Brazil is not available, such as the oneCollins et al. (1999) used. The first hypothesis (H1) is that earnings andreturns have a weak relationship as a result of the small demand forearnings as reducers of information asymmetry. The second hypothesis(H2) is that earnings do not incorporate economic income in a conserva-tive way because of the code law system adopted in Brazil, as previousresearch suggests. The third hypothesis (H3) is that book values domi-nate earnings to explain firms’ share prices. Initially, the relevance ofearnings and book values are tested according to the structure providedby Ohlson (1995) and used by Collins et al. (1997), and Harris et al.(1994). Using the cross-sectional and pooled time-series and cross-section regression below:

(1) Pjt = w0t w1tBVjt w2tEARNjt jt

Where:

Pjt stock price at the year ending 4 months after year-endBVjt book value per share for the period ending at time t

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EARNjt earnings per share for the period ended at time tjt error term at time t

Additionally, regression is decomposed (1), as suggested by Collinset al. (1997) to test the relevance of book values and isolated earnings.

(1.1) Pjt = w0t w1tBVjt jt

(1.2) Pjt = w0t w2tEARNjt jt

Under H3, R2 in regression (1.1) should be greater than in regression(1.2). A greater statistical significance is also expected in the regressioncoefficient on book values than on earnings. Under this hypothesis, earn-ings would not have incremental explanatory power over book values.

The expected irrelevance of earnings (H1) is tested in terms of thetraditional earnings-returns specification. This second specification isdesigned to investigate the role of earnings to explain securities’ behav-iour in Brazil. The specification used by Harris et al. (1994) is utilized toevaluate the role of accounting earnings for explaining returns:

(2) (Pjt djt Pjt 1)/Pjt-1 = 02t 1t(Earnjt Earnjt-1)/Pjt 1 2t

(Earnjt)/Pjt 1 jt

Where:

Pjt price of a share of company j at the end of year tdjt dividend per share of company j for year tPjt 1 price of a share of company j at the end of year t-1Earnjt earnings per share for company j for year tEarnjt-1 earnings per share for company j for year t-1jt error term at time t

Under H1, earnings have no role as information asymmetry reducersin Brazil. Thus, a low explanatory power for earnings levels andchanges is expected in regression 2, as well as in the coefficients, with-out much statistical meaning. This expectation is a direct result of earn-ings having no relation to securities’ returns for the sample investigated.In addition to the returns-earnings specification of equation 2, conserva-tism is also an important feature of earnings. Ball et al. (2001) showedthat conservatism (defined as asymmetric recognition of economic in-

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come) is a function of the corporate governance model in place. Morespecifically, they showed that common law countries present more con-servative earnings than code law countries. Investor (especially minor-ity investor) protection is greater in common law countries and firmsusually depend more on capital markets than on the credit market toraise funds, as is common in code law countries. Brazil is clearly classi-fied as a code law country, where earnings have no role to inform inves-tors. In this way, the hypothesis is raised that earnings do not present aconservative bias in Brazil. To investigate how effectively accountingincome incorporates economic income, the structure developed by Basu(1997) and used in an international context by Ball et al. (2001) isutilized to test H2. This specification is designed to confirm theirrelevance of earnings for incorporate economic income.

(3) NIjt = 0t 1tD 2tRjt 3tDRjt jt

Where:

NIjt net income for company j for year tD dummy variable that equals one if return Rjt is negative

and zero otherwiseRjt annual rate of return for company j at year t

jt error term at time t

This last test is designed to provide additional evidence of the inef-fectiveness of economic income incorporation by accounting income.In H2, this inability to incorporate economic income causes accountingearnings to be irrelevant and the coefficient on the dummy-return ( 3t)term to be statistically insignificant.

Data and Descriptive Statistics

Table 1 shows descriptive statistics for the sample, which was se-lected from the Economatica database for the period 1995-1999. In1993, the Plano Real was implemented and reduced inflation dramati-cally. Hence, this period was the first in Brazilian post-war history inwhich inflation declined to acceptable levels and economic stabilizationwas fully implemented. The sample shows the high standard deviationin the dataset, which confirms the variability of firm size and industryclassification traded on the Sao Paulo Stock Exchange (BOVESPA).

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Additionally, some aspects of the accounting system in Brazil can beconfirmed by the sample. Price-earnings ratios show that Braziliancompanies are relatively “cheaper” than their American counterparts.The book-to-market ratio shows that accounting systematically over-states market valuations in Brazil. This result is consistent with the flex-ibility allowed by accounting rules. It seems that managers use thisdiscretion and that market values do not correspond to the accountingmeasurement. Despite the elimination of outliers and companies withnegative equity3 book value, the final sample presents considerablevariance.

Results

The results presented in Table 2 show that accounting numbers aresignificantly relevant to explain prices. These results indicate that ac-counting information remains fully relevant despite the characteristicsof the corporate governance structure and capital markets in Brazil. Co-efficients on both book values and earnings remain statistically signifi-cant over the sample period, demonstrating that earnings and bookvalues are significant and present a high (compared to most U.S. stud-ies) and relatively stable explanatory power over the years.

The results of the two remaining specifications in Table 2 show thatbook values present greater explanatory power than earnings despite

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TABLE 1. Descriptive Statistics*

Variables Mean Stand. Dev. Median Max Min

Prices 0.37 0.99 0.03 14.51 0.0001

BV 0.78 1.53 0.08 10.07 0.001

Earnings 0.05 0.19 0.01 0.93 1.36

Economic income 18.55 101.90 10.08 860.78 92.89

P/E 4.22 12.57 3.27 90.85 60.91

BTM 3.75 3.74 2.40 25.55 0.18

* Descriptive statistics for 809 company-year observations ranging from 1995 to 1999, selected fromSão Paulo Stock Exchange (Bovespa). Outliers were eliminated according to several alternative meth-ods for all variables for each year studied. Firms presenting negative equity book value were eliminated.The number of companies is distributed as follows: 1995 (161), 1996 (159), 1997 (157), 1998 (145),1999 (187). Prices are stock prices at the year ending 4 months after fiscal year-end; BV are for bookvalue per share for the period ending at time t; earnings are earnings per share for the period ending attime t; economic income is the annual rate of return for company j at year t; P/E is the price-earnings ra-tio for each firm at the end of year t; BTM is the book-to-market ratio for each firm at the end of year t.

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earnings having statistically significant coefficients (at 1% significancelevels). The intercepts’ magnitude and statistical significance are lowerfor the book value specification than for the earnings model. Regardingstatistical significance, t-statistics are higher for book values than earn-ings in all periods analysed. These results are fully expected, given the

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TABLE 2. Tests of Relations Between Prices and Accounting Variables

Pjt = w0t + w1tBVjt + w2tEARNjt + jt

wot W1t w2t R2

1995 0.08 (3.53)* 0.15 (9.86)* 0.22 (1.17) 0.46

1996 0.09 (4.58)* 0.14 (9.43)* 0.68 (5.62)* 0.55

1997 0.10 (4.05)* 0.18 (7.83)* 0.73 (3.79)* 0.64

1998 0.06 (1.72)*** 0.25 (10.42)* 0.89 (4.85)* 0.64

1999 0.00 (0.01) 0.83 (13.62)* 0.54 (1.53)* 0.62

Pooled 0.06 (1.99)* 0.34 (16.95)* 0.78 (4.72)* 0.39

Pjt = w0t + w1tBVjt + jt

wot w1t R2

1995 0.08 ( 3.48)* 0.16 (11.76)* 0.46

1996 0.09 (4.42)* 0.17 (11.79)* 0.47

1997 0.09 (3.68)* 0.25 (15.73)* 0.61

1998 0.06 (1.59)*** 0.31 (14.34)* 0.59

1999 -0.01 ( 0.10) 0.88 (17.38)* 0.62

Pooled 0.06 (1.89)** 0.40 (22.09)* 0.38

Pjt = w0t + w1tEARNjt + jt

wot w1t R2

1995 0.18 (6.65)* 1.08 (10.60)* 0.14

1996 0.15 (2.77)* 1.15 (8.35)* 0.30

1997 0.16 (5.86)* 1.88 (12.64)* 0.50

1998 0.21 (4.91)* 1.92 (9.35)* 0.37

1999 0.50 (4.57)* 3.26 (7.78)* 0.24

Pooled 0.27 (8.21)* 2.18 (13.20)* 0.18

Notes: Pjt Stock price at the year ending 4 months after year-end;BVjt Book value per share for the period ending at time t;EARNjt Earnings per share for the period ending at time t;ejt Error term at time t;*, **, *** Significant at 0.01 level, 0.05 level and 0.10 level, respectively;

t statistics in parentheses. R2 are adjusted.

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Brazilian corporate governance structure and capital markets confirm-ing H3. This specification emphasizes the trade-off in the value rele-vance framework between earnings and book values. In this study, thistrade-off is explained in terms of information asymmetry and transmis-sion. Book values are expected to be relevant due to the study’s implica-tions for liquidation and debt covenants, for example. Negativecoefficients on earnings appeared in initial tests performed withoutdeleting firms with abnormal (outliers) losses. This confirms most ofthe Collins et al. (1999) findings.

The results presented in Table 3 confirm that, as expected, earningsdo not explain returns (H1). These results demonstrate clearly the lowquality of earnings in Brazil, confirming the idea that earnings are notused as an efficient mechanism to reduce information asymmetry. Table3 shows that earnings changes are statistically significant (10%), as areearnings levels (1%). However, the specification presents an extremelylow explanatory power, showing that earnings present a poor relation toreturns. In value relevance studies, it is always a question of arbitrarychoice to decide which level (R-square) can be considered relevant. Inthis study, R-square (adjusted) of 6% appears to be extremely low.

In Table 4, the asymmetric recognition of economic income by earn-ings is presented. The results show that, as expected, accounting incomedoes not incorporate economic income in a meaningful way. This fea-ture confirms the low quality of earnings. Conservatism is considered tobe a relevant feature of accounting information. Conceptual frame-works all around the globe, including Brazil, state that conservatism isimportant to maintain the reliability of accounting information. Ac-counting standards are much less conservative in Brazil than they are in

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TABLE 3. Tests of Relations Between Returns and Reported Earnings

(Pjt + djt -Pjt -1)/Pjt-1 = 0t1 + 1t(Earnjt -Earnjt-1)/ Pjt-1 + 2t(Earnjt)/ Pjt-1 + ejt

a0t a1t a2t R2

Pooled 0.01 (8.54)* 2.32 ( 1.73)*** 8.66 (3.43)* 0.06

Notes: Pjt Price of a share of company j at the end of year t;djt Dividend per share of company j for year t;Pjt –1 Price of a share of company j at the end of year t-1;Earnjt Earnings per share for company j for year t;Earnjt-1 Earnings per share for company j for year t;ejt Error term at time t;*, **, *** Significant at 0.01 level, 0.05 level and 0.10 level, respectively;

t statistics in parentheses.

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the U.S. Managers have more discretion to report earnings. Ashbaughand Olsson (2002) report that discretion causes an increase in earningsrelevance. The results herein show that earnings quality is not a functionof the level of discretion allowed in financial statements. Earnings qual-ity seems to be a function of the demand for accounting information,which in turn is a function of the corporate governance arrangementspresent in the economy.

Additional Analysis

Two additional analyses were performed on the sample selected. Ini-tially, the sample was divided into preferred and common shares. Themotivation for this split is the pervasive nature of preferred shares inBrazil. They are more common than in most countries and, as thoseshares do not have voting rights, they can be used to exploit sharehold-ers, as is the general perception in Brazil (Gazeta Mercantil, 2000). Be-cause of this feature, the accounting numbers are expected to be moreclosely related to common shares than to preferred shares, as account-ing numbers (book value of equity and earnings) represent fundamen-tals. Additionally, the variables in the levels regression were divided byprices at the beginning of the year (Pt-1) to control for scale effects, assuggested by Brown et al. (1999). Table 5 presents the descriptive sta-tistics for the split sample, and Tables 6, 7 and 8 present the results ofthe same specifications performed previously.

The results show that the scale effect is responsible for the elevatedR2 on the levels regressions (prices as the dependent variable). Exceptfor the earnings coefficient on the regression 1.2 for preferred shares,the significance of the variables changes in magnitude after the control

Alexsandro Broedel Lopes 63

TABLE 4. Contemporaneous Association Between Earnings and Returns

NI = 0t + 1tD + 2tR + 3tDR + jt

b0t b1t b2t b3t R2

Pooled 0.06 (5.41)* 0.00 (0.15) 0.00 (1.63) 0.00 (2.85)* 0.04

Notes: NIjt Net income for company j for year t;D Dummy variable, which equals one if return Rjt is negative, and zero otherwise;Rjt Annual rate of return for company j at year t;

jt Error term at time t;*, **, *** Significant at 0.01 level, 0.05 level and 0.10 level, respectively;

t statistics in parentheses.

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for scale, but they are not large enough to change the major conclusions.In the sample, the scale effect has a significant influence on the interpre-tation of the explanatory power of the equations performed, as well ason the magnitude of the coefficients estimated, as expected. Regardingthe common/preferred shares question, it can be observed from theanalysis of the deflated regressions that earnings seem to have a greaterrelevance to common shares. This conclusion is confirmed by thereturns/earnings and earnings/returns regressions. The scale effectcauses a bigger reduction in explanatory power for the sample of com-mon shares than for the sample of preferred shares. The initial hypothe-sis that accounting variables are less relevant to explain the behaviour ofpreferred shares is rejected by the comparison of the magnitude of theR2 for the two samples (R2 = 0.08 for the common shares sample and of0.15 for the preferred shares sample) using the deflated variables. Thecorrection for scale causes a bigger reduction in explanatory power forthe common shares sample. The conclusion of this analysis is that earn-ings are more relevant for the common shares sample than they are forthe preferred shares sample. This is true in terms of levels (prices) andreturns/earnings regressions.

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TABLE 5. Tests of Relations Between Prices and Accounting VariablesDeflated by Beginning of the Year Prices

Pjt = w0t + w1tBVjt + w2tEARNjt + jt

wot w1t w2t R2

Pooled 0.94 (16.64)* 0.11 (10.29)* 0.03 (1.10) 0.12

Pjt = w0t + w1tBVjt + jt

wot w1t R2

Pooled 0.94 (16.61)* 0.11 (10.44)* 0.12

Pjt = w0t + w1tEARNjt + jt

wot w1t R2

Pooled 1.34 (31.10)* 0.05 (1.94)*** 0.00

Notes: Pjt Stock price at the year ending 4 months after year-end;BVjt Book value per share for the period ending at time t;EARNjt Earnings per share for the period ending at time t;

jt Error term at time t;*, **, *** Significant at 0.01 level, 0.05 level and 0.10 level, respectively;

t statistics in parentheses. R2 are adjusted.

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Alexsandro Broedel Lopes 65

TABLE 6. Comparison of Valuation Properties of Accounting Numbers forCommon and Preferred Sharesi and Deflated by Beginning of the Year Prices

Pjt = w0t + w1tBVjt /Pt-1+ w2tEARNjt/Pt-1 + jt (Eq. 1)Pjt = w0t + w1tBVjt/Pt-1 + jt (Eq. 1.1)

Pjt = w0t + w1tEARNjt/Pt-1 + jt (Eq. 1.2)

Panel A: Common Shares Deflated by Pt-1

Eq 1 Intercept Book Value Earnings Adj R2

Coefficient T-statistics 1.22 (12.81)* 0.07 (2.75)* 0.12 (2.01)** 0.08

Eq. 1.1 Intercept Book Value Adj R2

Coefficient t-statistics 1.17 (12.69)* 0.09 (4.55)* 0.07

Eq. 1.2 Intercept Earnings Adj R2

Coefficient t-statistics 1.39 (19.47)* 0.22 (4.12)* 0.06

Panel B: Preferred Shares Deflated by Pt-1

Eq 1 Intercept Book Value Earnings Adj R2

Coefficient t-statistics 0.79 (11.23)* 0.12 (9.95)* 0.01 (0.21) 0.15

Eq. 1.1 Intercept Book Value Adj R2

Coefficient t-statistics 0.79 (11.25)* 0.12 (9.96)* 0.15

Eq. 1.2 Intercept Earnings Adj R2

Coefficient t-statistics 1.30 (24.16)* 0.00 (0.04) 0.00

TABLE 7. Tests of Relations Between Returns and Reported Earnings forPreferred and Common Shares

(Pjt +djt -Pjt -1)/Pjt-1 = 0t

2 + 1t(Earnjt Earnjt-1)/ Pjt-1 + 2t(Earnjt)/ Pjt-1 + jt

a0t a1t a2t R2

Preferred 15.03 (3.38)* 1.83 ( 0.71) 1.89 (0.60) 0.00

Common 23.12 (3.90)* 1.43 ( 0.86) 22.28 (4.67)* 0.07

TABLE 8. Contemporaneous Association Between Earnings and Returns forPreferred and Common Shares

NI = 0t + 1tD + 2tR + 3tDR + jt

0t 1t 2t b3t R2

Preferred 0.07 (3.92)* 0.01 ( 0.23) 0.00 (1.14) 0.00 (2.01)*** 0.03

Common 0.05 (3.05)* 0.03 (0.85) 0.00 (2.22)** 0.00 (1.73)*** 0.05

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CONCLUSIONS

This paper has evaluated the value relevance of accounting informa-tion in Brazil. Using a sample of firms traded on the Sao Paulo StockExchange (BOVESPA), it shows that earnings are not relevant to ex-plain returns and that accounting income does not significantly incorpo-rate economic income. These results confirm the hypothesis thatearnings in Brazil are of low quality by not being used to reduce infor-mation asymmetry. This result contributes to the idea that quality ofearnings is a function of the demand for accounting information. Thisdemand is clearly low in Brazil, given its corporate governance struc-ture and capital markets. Companies in Brazil are publicly traded, butdespite this fact, earnings are irrelevant. This result suggests that con-centration of ownership has dominant influence over accounting qual-ity. It seems that public trading does not provide an incentive strongenough to force managers to report conservative earnings. Clearly,earnings in Brazil serve other purposes than simply informing inves-tors. This function seems to be of low importance given the specialaccess to information that Brazilian dominant shareholders have. Thisirrelevance of earnings contrasts with the importance of book values toexplain prices as shown.

Research dealing with financial accounting information and corpo-rate governance is virtually non-existent, as demonstrated by Sloan(2001). Despite its abundance, research into corporate governance nor-mally ignores accounting questions. Few studies are asking meaningfulquestions regarding accounting and corporate governance. This sce-nario is even worse in emerging markets. Emerging markets provide ex-cellent research opportunities due to a very simple aspect: accountinginformation plays a central role in corporate governance arrangements.Managerial compensation, debt agreements, grid pricing contracts etc.,are a few examples of uses of accounting information to facilitate exter-nal monitoring. Accounting has little or no use without corporate gover-nance arrangements. In emerging markets, and especially in Brazil,accounting information has some idiosyncrasies caused by the contract-ing environment, which provides an excellent laboratory for testing. Ar-rangements related to inflation adjustment, debt contracts, litigation,bankruptcy rules, managerial compensation etc., are a few examples oftopics that deserve further investigation. Does accounting informationbecome more useful as risk (systematic and non-systematic) increases?What is the role of minority rights in external monitoring? Investigationinto these topics would increase our understanding of the impact of

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accounting information and disclosure on indicators of economicperformance.

NOTES

1. The ratio of the stock market capitalization held by minorities to gross nationalproduct for 1994.

2. To avoid misspecification, this is the coefficient on the 1/Pt-1 variable. This scalingestimates a weighted least square, which is the reason for using the 1/Pt-1 instead of thetraditional coefficient. Thanks goes to the editor for suggesting this correction over theinitial regression.

3. Book values can perform three possible tasks: proxy for scale effects, proxy forfuture abnormal profits and abandonment option. Under these possible explanationsthere is no role for negative book value of equity, and for this reason, firms exhibitingnegative book values were eliminated.

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Received: 17/02/2005Accepted: 25/07/2005

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