Interpretation of the Value Relevance Indicator With(out) Dummies

Abstract

In the value relevance (VR) literature, the R2 figure of a regression is considered the VR indicator. Furthermore, a financial reporting item is considered value relevant if its regression coefficient is statistically significant. The variation across the variables of interest is named unobservable heterogeneity (UH) which leads to biased estimators and generates incorrect inferences. The common approach of eliminating UH is adding dummies into a regression. However, this method adds the explanatory power of dummies to that of accounting items, and it eventually results in inflated R2 figures. Hence, R2 figures become misleading with dummies since R2 figures do not purely explain the VR of accounting items. This chapter suggests demeaning as an alternative methodology to deal with UH. Although demeaning and adding dummies are the same methodology of mitigating UH, this chapter documents that adding dummies inflates R2 figures while demeaning does not.