Is the Relationship Between Equity Value and Accounting Information Non-Linear? Empirical Evidence from Japan

Abstract

ABSTRACT Accounting information is vital for equity valuation. An issue that intrigues academic researchers, as well as investors and policy makers, is how equity value is related to accounting data. Ohlson (1995) developed a formal model that integrates earnings, equity book values and “other information component” via residual income valuation (RIM) and linear information dynamics (LIM) for valuing equity. Ohlson assumed the model to be linear and additive. However, in an important refinement of Ohlson's valuation model, Burgstahler and Dichev (1997) hypothesize and empirically provide evidence that the relationship between equity value and earnings and book value is non-linear based on the idea that firms have the option to discontinue unprofitable operations and adapt resources to alternative business uses. Burgstahler and Dichev find that the extent of association of equity value with earnings and book value is dependent on the level of the success of the firm. When the firm is “successful,” earnings is the more important determinant of equity value and when the firm is unsuccessful, book value is the more important determinant of equity value. Their empirical result was consistent with this proposition. The present study employs their methodology to evaluate whether the relationship between equity market value and accounting information departs from the linearity assumption in Japan. Using a large sample over a longer period of time, this study finds evidence that Burgstahler and Dichev's proposition also holds in Japan, although the result is weaker compared to U.S. result.